| PYQ Relevance: Mains: Q1 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. (UPSC IAS/2018) Q2 Distinguish between Capital Budget and Revenue Budget. Explain the components of both these Budgets. (UPSC IAS/2021) Prelims: Under which of the following circumstances may ‘capital gains’ arise? (2012) 1. When there is an increase in the sales of a product 2. When there is a natural increase in the value of the property owned 3. When you purchase a painting and there is a growth in its value due to an increase in its popularity Select the correct answer using the codes given below: (a) 1 only (b) 2 and 3 only (c) 2 only (d) 1, 2 and 3 |
Note4Students:
Prelims: Short-Term Capital Gains (STCG) and Long-Term Capital Gains (LTCG);
Mains: Impact of gambling instincts on the stock market;
Mentor comments: In India, capital gains are classified into two categories based on the holding period of assets. Short-Term Capital Gains (STCG) apply to assets held for 12 months or less, taxed at a rate of 15% for listed equity shares. In contrast, Long-Term Capital Gains (LTCG) are applicable when assets are held for more than 12 months, taxed at 10% for gains exceeding ₹1 lakh, with no indexation benefits. This framework encourages long-term investment while imposing higher tax rates on short-term trading activities.
Let’s learn!
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Why in the News?
The Indian government has increased taxes on both short-term and long-term capital gains from stock market investments in its latest Budget, along with raising the securities transaction tax on derivatives trading.
How capital gains occur
| Definition of Capital Gains: Capital gains are profits earned from the sale of an asset that has increased in value over the holding period. This occurs when the selling price exceeds the original purchase price. |
- Market Dynamics: In a perfect market where future cash flows are accurately forecasted, capital gains would not exist, as assets would be bought and sold at their fair value. However, in reality, uncertainty leads to mispricing, allowing investors to buy undervalued assets and realize gains when their true value is recognized.
- Investor Behavior: Investors who allocate capital efficiently into undervalued businesses can earn capital gains when others recognize the fair value of those businesses. Conversely, those who misallocate capital into overvalued assets may incur capital losses.
- Economic Implications: Efficient capital allocation is crucial for economic prosperity. Misallocation, such as investing in sectors with low demand (e.g., cruise ships during a pandemic), can lead to overall economic inefficiency and resource wastage.
- Taxation and Incentives: A uniform tax on capital gains may help mitigate resource misallocation, but it can also impact private investment incentives and overall economic growth.
Impact of gambling instincts on the stock market
- Increased Retail Participation: The Economic Survey 2023-24 highlights that the surge in retail investor participation in Futures and Options (F&O) trading is largely driven by inherent “gambling instincts.”
- This is evidenced by the rapid growth in trading volumes, with retail traders’ share in derivatives trading rising from 2% in 2018 to 41% in 2024.
- Potential for High Returns: Derivatives trading offers the allure of outsized gains, which appeals to investors seeking quick profits.
- High Risk of Losses: Despite the appeal of quick profits, the reality is stark; a study by the Securities and Exchange Board of India (SEBI) found that 89% of individual traders in the equity F&O segment suffered losses, with average losses of ₹1.1 lakh in FY22.
Gambling instincts are worse for derivatives
- Complexity and Misunderstanding: Derivatives are often misunderstood due to their complexity. This lack of understanding leads to a negative perception because many do not grasp their practical benefits and risk management functions.
- Speculative Nature: The speculative aspect of derivatives trading can resemble gambling, especially when neither party intends to buy or sell the underlying asset. This speculative behaviour is seen as risky and irresponsible, contributing to the negative reputation of derivatives.
- Risk Transfer: Derivatives allow for the transfer of risk from one group of investors to another. While this risk management is beneficial, the perception that some investors profit from others’ risk aversion can be seen as exploitative or opportunistic.
- Market Impact: Just as with active trading in the cash market, speculative trading in derivatives can be socially beneficial by providing liquidity and risk management tools. However, the public often overlooks these benefits and focuses on the perceived destabilizing effects and the potential for large, rapid losses, which can harm individual investors and financial markets.
Way forward:
- Investor Education: Need to implement comprehensive educational programs for investors to improve their understanding of derivatives and capital markets.
- Transparency in Trading: Need to increase transparency in derivatives markets by requiring more detailed disclosures about trading strategies, potential risks, and the impact of speculative trades.
