My father-in-law and niece both have their birthdays on the same day, so usually, 1 February is a day of double celebration in our family. This year however, it was also the day the Finance Minister had some not-so-good news for us (and equity investors)…
Currently, long term capital gains arising on sale of listed equity shares are not taxed. The budget proposes to now tax these gains at the rate of 10%. Many might feel that the index would fall to some extent as this is a negative for investors.
The purpose of this article is to estimate how much the market could possibly “correct” because of this proposal and also explain why and how a tax proposal can affect the index level.
The concept of expected returns on equities
Most people understand that equities are ‘riskier’ than debt and accordingly, they must demand a higher return from equities to make it lucrative for investment. Technically, expected return from equities is written as,
Expected return for equities = Risk free rate + Equity risk premium
Out of the two components of the above equation, the risk free rate is observable and in case of India it currently stands at 6.74%. We also compute the equity risk premium which as per our estimates stands at 3.63% as on 1 February 2018 (please refer the sidebar for an explanation of the inputs required to compute the implied equity risk premium and this post to understand how we compute the risk premium).
This gives us an expected return of 10.37% (6.74% + 3.63%) for the Indian markets. What this means is that given the level of the markets and expectations around growth in cash flows, Indian investors were demanding a total return of 10.37% as of 1 February 2018.
Note, however, that this return was not taxed earlier. For investors to remain in the same position on a post-tax basis, they would now have to revise their expectations upwards by the amount of tax levied. Thus, the new expected return would be:
Post-tax return = Pre-tax return * (1 – tax rate)
10.37% = Pre-tax return * (1 – 10%)
Pre-tax return = 10.37% / 90% = 11.52%
This means that in order to earn the post-tax return of 10.37%, investors now have to demand a return of 11.52% from Indian equities, i.e. 1.15% higher than what they were demanding previously. Therefore, other things remaining constant, the index level needs to correct to a level which where the expected return reaches the new equilibrium of 11.52%.
Going back to the equation of expected return, this 1.15% difference can get adjusted in either the:
- risk free rate; or
- implied equity risk premium.
If the entire difference of 1.15% gets adjusted in the risk premium, the new risk premium would be 4.78% (3.63% + 1.15%). Other things remaining the same, this implies an intrinsic value for the Nifty 500 of 6,560, i.e. a fall of over 32% from current levels.
On the other hand, if market forces adjust this difference entirely in the risk free rate, the index is likely to fall only around 8.50% to 8,870.
Between these two extreme scenarios, we could actually see this difference being adjusted in some proportion between both the risk free rate and the risk premium. The chart below provides the index level (and % fall in parenthesis) at various levels of adjustment of the increase in expected return.
Does this necessarily mean that markets will correct?
Not really. One of the important things that you may have noticed is the consistent use of the words, “other things remaining the same”. These are heavy words since in the real world everything changes constantly AT THE SAME TIME. Also, with many variables at play, it is impossible to precisely predict what second order consequences such a levy of tax may have. The purpose of this exercise then, is to figure out what is likely to happen, even though it may very well end up NOT happening.
In our personal view, there is a higher likelihood of markets correcting to some extent in order to compensate for the fall in post-tax expected returns. We are in for interesting times ahead and it will be fascinating to watch the action of investors in the coming months.
 The current Indian 10-year government bond rate is 7.61%. Reducing the default spread of 0.87% from this rate gives us the risk free rate for the Indian economy.