Tax cuts are a temporary fix for capital flows

Why in the News

Cuts in the long-term capital gains tax (LTCG) and the securities transaction tax (STT) are back on the table as India seeks to reverse slowing foreign investment. A June tax exemption on foreign investors’ bond income lifted inflows only briefly, so a tax cut may be a temporary fix that mainly makes it easier for investors to leave.

Why is India considering tax cuts to win back foreign capital?

1. Slowing foreign flows: Foreign investment has slowed, so the Reserve Bank of India (RBI) is weighing ways to support the rupee. Whether the Foreign Currency Non-Resident (FCNR) window, foreign currency deposits that non-resident Indians hold with Indian banks, has been useful is debated.
2. Global pull factors: Geopolitical risks and investors’ tilt towards technology firms pull money from developing markets, so India seeks to reverse outflows.
3. Appeal of tax cuts: Tax cuts are popular because they raise investor returns visibly and at once. It is unclear whether they treat the cause or only the symptom.

Did the June tax exemption on bond income work?

1. June package: The government exempted foreign institutional investors (FIIs), foreign funds buying Indian securities, from tax on interest and gains from Treasury bills, government bonds, dated securities and sovereign green bonds.
2. Short-lived rise: FII net debt investment rose to $5.5 billion in June and $3.36 billion in July, briefly easing the balance of payments.
3. Reversal: Net debt investment turned negative in later months and stayed weak.
4. The takeaway: The tax benefit fades quickly because it does not change how investors judge India’s risks.

What would cutting the capital gains tax and STT cost?

1. Substitution argument: Advocates of removing LTCG on equity say the STT, a small tax on every share trade, yields enough revenue. This premise dates to a budget speech two decades ago.
2. Capital gains revenue: Taxpayers reported Rs 9,751.5 billion in capital gains in 2022-23, so exempting LTCG on equity, even for FIIs alone, would cut revenue noticeably.
3. STT as a buffer: STT collections reached Rs 575.2 billion in 2025-26 and keep flowing when markets fall and capital gains shrink. Any cut must weigh this against better sentiment.

Does India tax capital gains more heavily than other countries?

1. Imprecise comparisons: Claims that India taxes capital gains more heavily than the United States are imprecise, because the outcome depends on treaty models and domestic priorities.
2. Source-based taxation: Of 1,973 tax treaty relationships, 1,106 let the country where the shares are situated tax the gains on their sale.
3. Common practice: Source-based taxing is common in India’s treaties and also applies to the United Kingdom, Australia, China, France and Germany. Exempting such income at home is a sovereign choice.

Should tax be used to attract capital at all?

1. Debt-equity parity: There is a strong case for taxing returns on debt and on equity alike, a long-running effort in India.
2. Easing the exit: A tax cut may help investors leave rather than keep them, so tax should be a last resort, using the least costly option.
3. Risk of reversal: Cutting taxes to lift market mood briefly makes a later rate increase likelier once debt and deficits pile up.

Challenges

1. Risk perception unchanged: Tax incentives do not alter the geopolitical and technology risks that steer global investors away.
2. Revenue loss: Exempting capital gains or cutting STT would cost revenue at a time of accumulating debt and deficits.
3. Policy uncertainty: A cut made to lift sentiment may later be reversed, adding to investor uncertainty.

Way Forward

1. Revenue impact statement: The Finance Ministry should publish the revenue cost of any LTCG or STT cut with its expected effect on inflows.
2. Parity first: Move towards equal tax treatment of debt and equity rather than one-off exemptions.
3. Treaty-based benchmarking: Compare India’s capital gains tax with treaty practice, not United States headline rates.

Conclusion

Tax cuts can lift inflows for a few months but leave untouched the risks that steer global capital. Whether policymakers adopt the LTCG and STT cuts or pursue debt-equity parity will show if tax stays a last resort.

What is Foreign Portfolio Investment (FPI)?

1. Meaning: Investment in shares and bonds for price gains and dividends, without control over the company. It is highly liquid and prone to sudden reversals in crises.
2. 10% line: A stake below 10% of a listed company’s paid-up equity is FPI. A larger stake is foreign direct investment.
3. Regulator: The Securities and Exchange Board of India (SEBI) regulates FPI under its Foreign Portfolio Investors Regulations, 2019.

Matching Previous Year Question

“[2010] A great deal of Foreign Direct Investment (FDI) to India comes from Mauritius than from many major and mature economies like UK and France. Why? (a) India has preference, for certain countries as regards receiving FDI (b) India has double taxation avoidance agreement with Mauritius (c) Most citizens of Mauritius have ethnic identity with India and so they feel secure to invest in India (d) Impending dangers of global climate change prompt Mauritius to make huge investments in India ANSWER: (b)”