Stock market shrugs off capital gains tax hike in the Budget

On one hand, fund managers, who are in the business of managing other people’s money (OPM), like to get into the minutiae of the government’s budget, as they try to figure out new investing opportunities to make more money for themselves and their investors.

On the other hand, they also look at the budget in a broader sense, largely looking at two main aspects. First, which way is the government’s fiscal deficit headed? And second, are there any changes in the taxation of capital gains from the buying and selling of shares? Needless to say, nobody likes paying more tax than they already are paying.

For those in the business of managing OPM, the budget presented on 23 July, turned out to be good on the first count and not so good on the second.

The government’s fiscal deficit—the difference between what it earns and what it spends—is projected to be at ₹16.1 lakh crore in 2024-25 or 4.9% of India’s gross domestic product (GDP). GDP is the measure of the economic size of the country. The fiscal deficit was ₹16.5 lakh crore or 5.6% of the GDP in 2023-24. So, a drop in the fiscal deficit is expected in both absolute and percentage terms.

In 2020-21, as the pandemic spread, two things happened. First, the economic activity ground to a halt and thus the taxes collected by the government also collapsed. Second, the government had to spend more money to revive economic activity. It became the spender of last resort.

This led to the fiscal deficit jumping to a massive ₹18.2 lakh crore or 9.2% of the GDP during the financial year. Since then, the government has been trying to cut down its fiscal deficit.

Now, why is this important for the OPM wallahs and the stock market? This is because a higher fiscal deficit means that the government has to borrow more to fund that deficit. This raises the country’s public debt and, as history has shown us over and over again, that’s not a good thing beyond a point.

But more importantly, when a government borrows more, it leaves less money for others to borrow and thus pushes up interest rates. Higher interest rates hurt both consumers and corporations. Consumers spend less, so corporations earn less or at least not as much as they did in the past. Also, at higher interest rates, corporates are reluctant to borrow and expand. Further, corporations that have already borrowed money need to pay higher interest on that debt. This hurts profitability and, in turn, their stock price. This is something that the OPM wallahs but naturally don’t like.

Of course, things are not as straightforward as this, but this is the general idea behind why the stock market likes the government to run a lower fiscal deficit unless the economy is in major trouble as it was in 2020-21. The government delivered on this front with the fiscal deficit in 2024-25 projected to fall 4.9% in 2024-25 of the GDP, from 5.6% in FY24.

That was one part. Now, let’s take a look at the second.

Over the years, stocks have been a lucrative form of investing. A major reason for this is that capital gains on buying and selling stocks were taxed at lower rates than salaried income or income earned from fixed deposits.

Till Budget 2018, long-term capital gains on stocks were not taxed at all. Up until FM Nirmala Sitharaman presented the latest budget, they were taxed at 10% for gains exceeding ₹1 lakh in a year. This has now been increased to 12.5% for gains above ₹1.25 lakh in a year. Similarly, short-term capital gains tax on shares has been increased to 20% from 15%.

An increase from 10% to 12.5% in long-term capital gains tax and from 15% to 20% in short-term capital gains tax isn’t going to make any major difference to their investing plans. At best, it’s a small blip. There is still a lot of money to be made and this increase, they think, is just too small to make any material difference. That’s the story they seem to be telling themselves, at least as of today. The irrational exuberance is expected to continue. But then tomorrow is another day.