Union Budget 2024: Investors Hold Breath Amid Capital Gains Tax Concerns; How Will The Market React?

The stock market, which closed at a record high last Thursday (July 18) with the Nifty ending at 24,801, has entered a phase of cautious stagnation. As of Monday, the Nifty closed 21.60 points down at 24,509.30, despite positive market breadth. This pause in momentum reflects the market's apprehension ahead of the Union Budget announcement, particularly regarding potential changes in capital gains tax.

Last Thursday marked a milestone for the markets as the Nifty closed at a record high of 24,801. This achievement was celebrated, indicating robust market sentiment and investor confidence. However, the euphoria was short-lived, as the market took a more cautious stance in the subsequent trading sessions. By Monday, the Nifty had retreated slightly, closing at 24,509.30, reflecting a cautious sentiment as investors braced for possible announcements in the Union Budget.

Capital Gains Tax

Market insiders have expressed concerns that an increase in capital gains tax could have a detrimental impact on market sentiment. The current buzz suggests that the Union Budget might introduce higher taxes on capital gains, which has caused considerable anxiety among investors. A hike in capital gains tax could dampen the current buoyancy in the market, which has been driven by strong corporate profitability and positive economic indicators.

V K Vijayakumar, Chief Investment Strategist at Geojit Financial Services, highlighted the market's sensitivity to changes in capital gains tax. He noted, "A highlight of the Economic Survey, from the market perspective, is the data regarding corporate profitability which has quadrupled in 3 years from Rs 5.3 lakh crores in FY20 to Rs 20.6 lakh crores in FY24. For Nifty 500 companies, the corporate profit to GDP ratio has risen to a 15-year high of 4.8% in FY24. The market, which in the long run is a slave of earnings, is discounting this sharp turnaround in earnings."

"Corporate profitability is likely to improve further in FY25. This can keep the market resilient despite elevated valuations. The market participants will be closely watching for any tweaks in LTCGs tax. If there are no changes in LTCGs tax, that will be a big relief for the market and the market is likely to react positively to that. Stock-specific reactions will depend on the Budget proposals for specific sectors," Vijaykumar added.

Potential Impact of a Tax Hike

A potential increase in capital gains tax has sparked debates among market participants about its efficacy and potential consequences. Many argue that such a move may not significantly boost government revenues but could instead harm investors and companies looking to raise capital. The introduction of capital gains tax in Budget 2018 already created a framework that imposes a 15% short-term capital gains tax (SCGT) on equity holdings sold before one year and a 10% long-term capital gains tax (LTCG) on gains over Rs 1 lakh in one year.

Siddhartha Khemka, Head of Retail Research at Motilal Oswal Financial Services Ltd, commented on the market's current sentiment: "Nifty opened gap down on account of global sell-off and weak results from heavyweights but soon recovered and traded sideways throughout the session. It finally ended mildly lower at 24,509 levels. The broader market however recovered from the last few days sell-off and gained ~1%. Auto, Metals and Pharma gained more than 1% while IT, FMCG, Realty and Energy were the losers to the tune of 0.5%. Rising US-China tension, US President Joe Biden's withdrawal from the presidential race, and mixed set domestic earnings so far, especially from heavyweights have dented investor sentiments.

"Moreover, the market is cautious ahead of Union Budget tomorrow, especially given the conservative growth forecast in the economic survey released during the day. Though the budget is largely expected to be growth-oriented, with the announcement of some measures aimed at addressing the rural economy; this is largely factored in by the market. Investors will look out for signs of further traction. We could see some volatility tomorrow along with sector and stock-specific actions," added Khemka.

Economic Survey Insights

The Economic Survey released on Monday provided a mixed bag of data, some of which has implications for market expectations. The survey highlighted a quadrupling of corporate profitability from Rs 5.3 lakh crores in FY20 to Rs 20.6 lakh crores in FY24, with the corporate profit to GDP ratio for Nifty 500 companies reaching a 15-year high of 4.8% in FY24.

However, the survey also referenced a June 2024 IMF staff paper that recommended: "well-designed excess corporate profit taxes and high personal income taxes on capital through better enforcement of automatic information exchange between countries and enhanced taxation of capital gain." While this recommendation aims to address inequality caused by large-scale labour displacement due to AI adoption, its appearance in the survey has fueled speculation about potential tax hikes in the upcoming budget.

Aditya Gaggar, Director of Progressive Shares, provided a technical perspective on the market's current positioning: "A swift recovery in the broader markets helped the Index limit its losses to close at 24,509. Considering the Union Budget announcement today, wild swings can be expected on both sides where 24,200 will be the immediate support while the higher side seems to be capped at 24,800. In the case of BankNifty, the support is placed at 51,920 while resistance is set at 52,750. We hold the same stance on the sectors we stated earlier, i.e., bullish on FMCG/IT and bearish on Auto. However, positive development in the budget can change the trend of the markets. Investors should wait and watch before taking any action."

The market's cautious stance is also influenced by political factors, with some participants expressing that a higher capital gains tax poses a greater long-term threat than potential political instability resulting from the BJP's parliamentary tally falling below the 270 mark.

As the market awaits the Union Budget announcement, the spectre of a potential hike in capital gains tax looms large. While corporate profitability and strong economic indicators have provided a buffer, the market's reaction to the budget will hinge on the specifics of any tax changes. Investors and analysts are bracing for potential volatility, with the hope that the budget will provide clarity and avoid measures that could dampen market sentiment.

In the words of V K Vijayakumar, "The market, in the long run, is a slave of earnings." As such, the focus will remain on corporate performance and the broader economic landscape, with the hope that any policy changes will support continued growth and investor confidence.