For sensible capital gains taxation

The government’s proposed direct taxes code has been widely welcomed. It seeks, rightly, to bring corporate tax rates closer to the Chinese and combine lower rates with fewer exemptions.
Experts have already analysed most proposed changes threadbare. But virtually none have focused on one area where the proposed code goes seriously wrong — capital gains tax. Indeed, the underlying issues are fundamentally misunderstood globally.

Any financial expert will tell you that it is prudent to diversify your savings, putting them in different asset classes (shares, bonds, real estate). It is also prudent to diversify within each asset class like shares
— you should distribute your holdings of shares between different sectors such as finance, auto, healthcare, and IT. The sums you allocate to different assets should change with time — textiles constitute a sunset sector and IT a sunrise sector, and you should reshuffle your portfolio accordingly. A fund manager who never reshuffles his portfolio will be sacked on the ground of incompetence. He will be guilty of having harmed the savings of the clients whose interest he is supposed to serve. Yet the proposed capital gains tax will exempt people who never sell any assets, and penalise those who do. Assets rise in value whether they are sold or not. Reshuffling a portfolio of assets means selling some assets and buying others. The proposed tax will be levied only on gains from sales, not on gains in the value of unsold assets. So although reshuffling is economically efficient and financially prudent, the proposed code will tax this good practice and exempt the bad alternative. That is terrible policy.

It makes better sense to levy capital gains tax only on assets that are liquidated — converted to money. Portfolio reshuffling should be encouraged, and so the new tax code should exempt reshuffling. Three considerations should govern any tax proposal: efficiency, equity and simplicity. That is, a tax should promote economic efficiency and provide incentives for desirable behaviour; it should aim for vertical equity (rich folk should pay more) and horizontal equity (some sorts of gains should not get preferential treatment over others); and it should be simple to administer, reducing litigation and evasion. The proposed change in capital gains tax fails on all three counts—efficiency, equity and simplicity. International studies show that revenue from capital gains tax is typically under 1% of total revenue. It is nevertheless widely used to check the conversion of income into capital gains to avoid tax (zero coupon bonds are one example of such conversion). For the same reason, many countries levy gift tax: this too yields little revenue but checks evasion. This, then, is a sound reason for levying capital gains tax in India. It also improves vertical equity to the extent it gathers revenues from rich folk who are taxed relatively lightly today.