Attracting foreign capital needs more than tax cuts

Why in the News

Foreign portfolio investors (FPIs) have taken $51 billion out of Indian equity markets since 2024-25, prompting calls to review the long-term capital gains tax regime. The outflow raises the question of whether tax cuts alone can bring foreign capital back, or whether India needs a wider regulatory and tax overhaul.

What is foreign portfolio investment, and why does tax matter to it?

1. Foreign portfolio investment: Foreign investors buy Indian shares and bonds for returns, not control. The money works like a bank deposit the owner can withdraw at short notice.
2. Volatile by design: Portfolio investors do not run the firms and can sell their holdings easily, so the money leaves quickly when global conditions turn against a market.
3. Long-term capital gains tax: A tax on the profit from selling an asset held for a longer period, so a lower rate raises the investor’s return after tax.
4. The takeaway: Tax is only one of several forces deciding where global portfolio money goes, so a tax cut addresses only part of the outflow.

Why has foreign capital left India?

1. Artificial intelligence (AI) boom: Global investors are buying into companies across the AI chain, where India has no significant presence. Eg. Nvidia, Google, Samsung, SK Hynix and TSMC.
2. Higher yields in rich economies: The 10-year US government bond pays around 4.9 per cent. That lifts the risk-free rate, the return earned without risk, so capital moves there.
3. Earnings and valuations: Investors also weigh what companies are expected to earn against what their shares cost, a further but less clear-cut reason for the exit.
4. Tax not the main driver: The Finance Minister has cautioned that tax concessions are not what mainly moves stock markets, and the causes above bear this out.

What has the government done, and what more is needed?

1. Bond market concessions: In June, the government made foreign investors’ interest income and capital gains on government bonds tax-free. It also simplified investment norms to draw in more foreign investors.
2. Global financial centre: To become a global financial centre, a hub where international investors raise and trade money, India needs regulation and taxes matching friendlier jurisdictions.
3. Ease of entry: Further steps should make it simpler for foreign capital to come in, not only lower the tax it pays.

Should foreign investors get tax terms that domestic investors do not?

1. Discrimination against rupee investors: Lower taxes for foreign investors alone would put rupee investors, the domestic investors who invest in rupees, at a disadvantage.
2. Finance Minister’s question: The Finance Minister asked, “If you pitch for dollar (investors), what about rupee (domestic) investors?”
3. Money sent abroad: Residents sent over $20 billion abroad under the Liberalised Remittance Scheme (LRS) in the first eight months of 2026. Curbing these outflows would be a step backwards.

Challenges

1. Global pull factors: India cannot control US bond yields or the AI investment cycle, which drive much of the outflow.
2. Missing AI presence: India has no significant firms in the AI chain, so funds chasing AI have little to buy in Indian markets.
3. Equal treatment: Any tax relief offered only to foreign investors invites the charge of discriminating against domestic investors.
4. Pressure to curb outflows: Large outward remittances create a temptation to restrict them, which would reverse the opening of India’s capital account to money moving across borders.

Way Forward

1. Benchmark the framework: The Finance Ministry should align India’s regulatory and tax regime with competing financial centres, rather than offering one-off tax cuts.
2. Uniform tax treatment: Design any change to capital gains tax for foreign and rupee investors alike.
3. Keep the LRS open: Leave outward remittances under the LRS free of new curbs.
4. Extend bond-market easing: Apply the streamlined investment norms used for government bonds to other segments where foreign investors face friction.

Conclusion

India’s foreign capital outflow is driven mostly by global forces that a tax cut cannot reverse. The open question is whether policymakers build a competitive framework for all investors, or reach for foreign-only concessions and curbs on money leaving the country.

Back2Basics: Liberalised Remittance Scheme (LRS)

1. What it is: A facility that lets resident individuals send money abroad.
2. Legal basis: It is governed by the Foreign Exchange Management Act, 1999 (FEMA).
3. Annual limit: A resident individual can remit up to USD 250,000 a year under the scheme.

Matching Previous Year Question

“[2018, GS3, 10 marks] Comment on the important changes introduced in respect of the Long term Capital Gains Tax (LCGT) and Dividend Distribution Tax (DDT) in the Union Budget for 2018-2019.”