Social implications of capital gains

Source: The post social implications of capital gains has been created, based on the article “The social benefits of stock market speculation” published in “The Hindu” on 6th August 2024

UPSC Syllabus Topic: GS Paper3- Economy-mobilisation of resources

Context: The article explains that raising taxes on stock market profits is based on the belief that such gains are like gambling. However, it argues that stock market speculation helps efficiently allocate capital and manage risks, benefiting the overall economy.

For detailed information on Changes in India’s tax regime for capital gains read this article here

Why did the government raise taxes?

1. The government raised taxes on capital gains to reduce speculative activities in the stock market, which are seen as similar to gambling.
2. The Economic Survey suggested that developing countries like India should not waste limited savings on speculation.
3. Finance Secretary T.V. Somanathan noted capital gains are the fastest-growing income class, justifying higher taxes.
4. The budget also removed indexation benefits for real estate investors to address perceived easy profits.
5. These measures aim to encourage long-term investments and ensure better allocation of capital towards productive sectors, rather than speculative activities.

How do capital gains occur?

1. Capital gains happen when an investor buys an asset at a lower price and sells it at a higher price. In a perfect world, with accurate future forecasts, there would be no capital gains.
2. However, due to uncertainty, some businesses are undervalued or overvalued. Efficient investors earn capital gains by investing in undervalued businesses.
3. For example, if a business is expected to yield ₹110 in a year and investors want a 10% return, they would pay ₹100 for it. If an investor buys it for ₹50 and sells it at ₹100, they gain 100%.

What are the social implications of capital gains?

1. Efficient Resource Allocation: Capital gains occur when investors correctly identify undervalued businesses, leading to better allocation of resources.
2. Economic Growth: Proper capital allocation results in overall economic growth, as seen when investors prioritize sectors in high demand, such as healthcare during the COVID-19 pandemic, over less critical sectors.
3. Liquidity and Market Functioning: Speculative activities provide liquidity, enabling long-term investors to buy and sell shares easily, which aids in the efficient functioning of the stock market.
4. Risk Management: Derivatives trading helps manage risk by allowing investors to lock in prices for future transactions, crucial for sectors like agriculture. Without such tools, farmers may be discouraged from producing due to price uncertainty.
5. Potential Misallocation: High taxes on capital gains and derivatives may deter efficient investment, leading to potential misallocation of resources and hindering economic growth.

Question for practice:

Examine the reasons why the Indian government decided to raise taxes on capital gains and the social implications of this decision.