Tax cuts are a temporary fix for capital flows

Off late, policymakers have been worried about the slowing down of foreign investment flows. The Reserve Bank of India (RBI) has been compelled to look into options to support the rupee, and the debate over whether the Foreign Currency Non-Resident (FCNR) window has been useful in addressing the issue at hand continues. One thing is clear: That the geopolitical risks and the tech bias of investments have created a conundrum for developing markets like India that are in search of ways to reverse capital outflows.

Among the policy options, tax cuts are more popular, arguably for their discernible and immediate impact on investor returns. But would removing taxes fix the cause, the symptom or neither?

The answer to this question is layered. In June, the Government of India introduced a package of reforms to support investment inflows. This included the exemption of interest income from tax and capital gains tax accruing to FIIs on sale of T-bills, government bonds, dated securities and sovereign green bonds. Debt investments by FIIs picked up in response.

The tax cut offered temporary respite in the balance of payments, as FII net investment in the debt segment increased to $5.5 billion and $3.36 billion in June and July respectively. This increase, however, did not sustain as net investments for subsequent months turned negative and remained subdued. It is reasonable to infer that the impact from tax benefit fades soon and investors are not convinced if risk perceptions are altered with such incentives.

Nevertheless, cuts in long-term capital gains tax (LTCG) and securities transactions tax are back on the table. These proposals need to be considered closely for their revenue and investment implications.

The advocates for the removal of LTCG on equity argue that the securities transaction tax offers enough revenues, and either of the taxes should apply. The premise that these taxes are substitutable can be traced back to the budget speech from two decades ago. A lot has changed since, as then finance minister Arun Jaitley in his budget speech said while reintroducing the tax that exempted LTCG from listed shares and units. Long-term capital gains income reported by taxpayers has increased since. In FY 2022-23, long- and short-term capital gains reported by all taxpayer categories was Rs 9,751.5 billion.

Therefore, an exemption of LTCG on equity, although to FIIs, could have a notable impact on revenues. The STT also, in part, fills in for the fall in short-term capital gains and trading incomes when markets correct. The collections from STT have increased markedly and were Rs 575.2 billion in FY 2026. So, the proposals must weigh the revenue lost against the anticipated shift in investor sentiment from these taxes.

A comparison with other countries like the United States is often drawn to suggest that India taxes capital gains more onerously. Such comparisons are imprecise as it depends on the tax treaty model and domestic priorities.

Of the 1,973 treaty relationships observed, 1,106 tax gains on transfer of shares or interest in the state where they are situated. That is, source-based treatment is not just common in treaties with India but is also the case for countries like the United Kingdom, Australia, China, France and Germany, to name a few. Whether source countries choose to exempt such incomes from domestic tax is a sovereign decision.

Nevertheless, there is a strong case for creating parity in tax between debt and equity — an effort ongoing for a long time in India. A tax cut, however, may only be a temporary fix, if at all. Moreover, a tax cut in the current context could end up easing the exit for investors.

If India is to pursue tax as the measure of last resort, it must choose the least costly among the options. Those who advocate for the removal of taxes, too, must remember that it is a double-edged sword — accepting it as a means to temporarily lift the mood of the market makes an increase in tax rate likelier when debt and deficits accumulate.

The writer is associate professor, National Institute of Public Finance and Policy, New Delhi and senior visiting fellow, CETEx, LSE