While the recent Union Budget announced a number of changes related to taxation policies – like a change in corporate tax rate, a standard deduction of Rs 40,000 for the salaried class, changes in surcharge – one of its most noteworthy aspects is a departure from the past policy stance on two areas of taxation. One, an increase in customs duties for a number of products, and two, the reintroduction of long-term capital gains (LTCG) tax.

Both of these changes have attracted considerable attention and wide-ranging comments from a number of stakeholders and commentators. Interestingly, however, some of the criticism of these policies has come from within the government.

The current and previous chairpersons of NITI Aayog, namely Rajiv Kumar and Arvind Panagariya, have both criticisedthe increases in custom duties; while Surjit Bhalla, a member of economic advisory council to Prime Minister Modi, termed the reintroduction of the LTCG tax as ‘most absurd policy initiative of the government without any justification’. In such context, this article analyses both the changes, the rationale behind them and their potential implications.

Import substitution

Since the economic liberalisation of 1991, the broad trend has been the reduction of customs duties to facilitate free cross-border movement of goods. However, this Budget reversed that trend, at least in case of some goods. The latest Union Budget has announced that for a number of goods, the custom duty will be increased.

Examples of such goods are – parts of automobile, mobile phones and accessories, electronic screens, other electronic items, cars, motorcycles, footwear, etc. The motivation behind these increases is a policy which is known as ‘Import Substitution Industrialisation Policy’ (ISIP). The basic argument is – if a country is importing a good x, then increase in custom duty on x will make it costlier, providing the incentive for the domestic production of x or substitution by similar goods produced domestically. So, if successful, it can lead to increase in domestic production in place of import, thus aiding employment creation and overall economic growth.

However, there are a number of criticisms of the policy which can be broadly classified into two categories – in terms of feasibility, and in terms of desirability that costs of ISIP outweigh the benefits.

Those arguing against the feasibility of ISIP point out that India had tried this policy in the past and did not succeed, and hence it will fail this time as well. This argument, however, misses the important point that the situation in India today is not exactly the same as that in the past. One crucial aspect for the success of ISIP is the capacity for domestic production which requires easy availability of factors such as skilled labour, machinery, finance, infrastructure, etc.

In all of these factors, India is better placed today than any time in the past. It should also be noted that the production doesn’t necessarily have to be done by the domestic Indian companies; it can also be done by foreign companies through foreign direct investment. The current increases in customs duties have been preceded by many other policy changes over the last few years, which seek to promote foreign direct investment in the country which wasn’t the case during the earlier ISIP period.

There are concerted efforts by the government to promote investment and overall ease of doing business; and, in the last few years, India has seen unprecedented FDI inflows. In fact, it can be argued that an increase in customs duties is, in essence, an additional incentive for the foreign companies to shift production to India/start production in India rather than import goods from other countries for the Indian market.

Even the domestic companies have seen a drastic improvement in the last few decades such that India is now one of the largest emerging sources of outward-directed investment (ODI). An appropriate policy incentive can induce the companies behind ODI towards industries identified in ISIP. All these changes mean that India is better situated today than any time in the past for a successful implementation of ISIP.

The critics arguing on the basis of desirability point out that it will be an extra burden on the consumers as products will become costlier. Though true, this is a narrow and short-term perspective in the sense that while lower customs duties do result in lower prices for consumers, they also lead to increase in the country’s import bill, and an increasing import bill can have ramifications for the macroeconomic stability of the country.

In recent years, other than petroleum products, the major sources of increased import bill have been electronic products, and the demand for electronic products are expected to increase even further surpassing petroleum bill by 2020. If unchecked, this rapidly increasing import bill can have consequences for the balance of payments situation, and a balance of payments crisis will have far deeper adverse consequences not only for the consumers of those products but also the entire country.

Another point being missed by critics highlighting the cost is that other potential benefits, such as job creation and economic growth, outweigh the minor increase in prices. In such a context, import substitution industry growth policy seems to be a useful strategy to achieve multiple goals of reducing the import bill and providing incentives to investment and employment within the country.

Re-introduction of LTCG

In case of sale of assets – like equities, bonds, real estate – if the selling price is higher than the buying price, the difference is referred to as capital gains. For taxation purposes, depending on the duration between the date of buying and the date of selling, capital gains can be categorised as either short term or long term. For the listed stocks, if the duration is less than 12 months, it is classified as short-term capital gains (STCG), while for a duration longer than 12 months it is classified as long-term capital gains (LTCG).

Earlier, in the Union Budget for 2003-04, the then finance minister Jaswant Singh had announced that long-term capital gains will be exempted from capital gains taxes. The motivation behind this move could be explained on two counts – promoting higher foreign financial inflows in India to fund current account deficit, and to deepen the Indian capital market.

Historically, India runs a current account deficit on international trade, meaning it imports more than it exports. Hence, it requires foreign capital (in the form of direct investment or portfolio investment) to fund the current account deficit or, in other words, to pay for excess import over export.

However, in the last few years, the situation has changed on both fronts. India’s dependence on foreign portfolio investment to fund the current account deficit has reduced significantly due to increase in foreign reserves, increase in remittances, as well as an increase in foreign direct investment. Meantime, the capital market in India has also expanded significantly, as visible from the Bombay Stock Exchange Sensex, which has risen from less than 6,000 points in March 2004 to 36,000 points in January 2018. These developments mean that the motivations behind the exemption of LTCG tax no longer exist.

Recent years also saw some new developments that support the re-imposition of LTCG tax. The exemption essentially means that the Indian government loses potential revenue which could have accrued from LTCG tax. The current government has put an emphasis on reducing the fiscal deficit to the targeted level of 3% of GDP over the years, and to meet this target it is imperative that the government is able to raise more revenue.

LTCG tax presents one such opportunity. As per the Budget speech 2018-19, in the assessment year 2017-18, the amount of capital gains earned has reached Rs 3,67,000 crore, and a 10% tax rate is expected to accrue about Rs 20,000 crore in the financial year 2018-19. There are some commentators who term this target as unrealistic; for example, Surjit Bhalla, a member of economic advisory council to the prime minister, expects the amount to be around Rs 5,000 crore in next financial year.

These differing revenue expectations perhaps arise from their differing estimation of how financial markets will react to LTCG tax. Financial markets are an interplay of a number of domestic and international factors; hence the future movements of financial markets are inherently difficult to predict. This uncertainty also makes the revenue projection of LTCG tax difficult; however, if the trend of last few years in financial market holds, the revenue projection can be achievable.

Though, revenue generation is not the only reason behind LTCG tax. Another aspect of capital gains taxes relates to the income/ wealth inequality. The data published by Central Board of Direct Taxes for the assessment year 2015-16 shows that almost 97% of capital gains are earned by a mere 78,ooo firms or individuals, many of whom are likely to be high net worth individuals (HNIs).

Recently, there have been many reports which highlight the problem of income and wealth inequality, and the fact that a major source of income of HNIs and firms were not being taxed has received criticism. Finally, last few years have also seen a trend where financial markets are growing at a rapid pace, however, the real physical investment has dropped to a multi-year low. This indicates the preference for financial investment over actual industrial investment.

Reintroduction of LTCG tax has the potential of changing the preference of investors from financial markets to industrial investments. Overall, it can be argued that LTCG tax is aimed at multiple objectives, like increasing revenue, as a tool for redistributing income, as well as an incentive for investors to move from purely financial to physical investment.

Union Budgets are annual events, and while each budget changes things to some extent, the broad direction of policymaking remains largely the same. The significance of Union Budget 2018 lies in the fact that it changes the very direction of policymaking on two tax policies. Firstly, it acknowledges or rather asserts that financial investors in India don’t need incentives anymore and need to contribute towards the much-needed growth in tax revenue; secondly, instead of freer trade movements, it adopts an import-substitution industrial growth policy.