Indian stock markets are grappling with sustained foreign portfolio investor (FPI) outflows, prompting calls for long-term capital gains (LTCG) tax reduction in the upcoming Budget 2026. The market's underperformance relative to Asian peers has intensified focus on policy measures that could restore foreign investor confidence.

Record FPI Outflows Continue

According to NSDL data, FPIs have net sold Indian stocks worth significant amounts, creating substantial market pressure. The selling pattern shows sustained foreign investor exodus across multiple months.

The sustained selling pressure led to a 2.5% decline in Nifty for the week ended January 23rd, highlighting the significant impact of foreign investor sentiment on market performance.

Market Performance Amid Challenges

Despite extending its annual bull run to the 10th consecutive year, Indian markets showed relative underperformance. The BSE Sensex rose 9% last year, but this return was substantially lower than the 16-68% returns offered by some Asian peers, including Pakistan's KSE 100 index. The underperformance stemmed primarily from sentiment issues and missing foreign flows rather than weak fundamentals.

Budget 2026 Expectations

Market participants are advocating for specific tax policy changes to improve investor sentiment:

• LTCG Tax Reduction: From current 12.5% to 10%
• STT Rollback: To encourage higher FPI participation
• Enhanced Exemption Limits: Building on current ₹1.25 lakh threshold

The government had reintroduced LTCG tax on equities in Budget 2018 at 10% with ₹1 lakh exemption. However, in 2024, the LTCG tax rate was raised to 12.5% with exemption limit of ₹1.25 lakh, while STCG increased to 20% from 15%.

Expert Analysis on Tax Cut Impact

Khushi Mistry, Research Analyst at Bonanza, noted that demand for lower capital gains taxes merits consideration amid 2025's market underperformance and FII outflows, as cuts historically boosted retail participation during the 2004 LTCG exemption era.

However, analysts remain cautious about the standalone impact of tax cuts. Harshal Dasani, Business Head at INVasset PMS, explained that even modest LTCG cuts would improve post-tax returns marginally but may not materially change the risk-reward equation for large offshore funds that allocate capital based on growth durability, liquidity depth, and macro stability.

Broader Factors Affecting FPI Flows

According to Dr VK Vijayakumar, Chief Investment Strategist at Geojit Investments Limited, two key factors could resume FPI buying in India:

• Corporate Earnings Improvement: Expected in Q4 FY26
• India-US Trade Deal: Timeline remains unclear, creating market uncertainty

Mistry believes that while tax reductions could trigger short-term rallies through sentiment improvement, similar to post-2004 gains, they won't guarantee sustained bull runs without accompanying earnings growth. The analyst emphasized that while tax tweaks provide support, macroeconomic factors and FII flows remain dominant market drivers.

The ongoing FPI selloff reflects broader concerns including weakening Indian rupee, elusive India-US trade deal progress, and slowing earnings growth, suggesting that comprehensive policy measures beyond tax cuts may be necessary to restore foreign investor confidence.

Indian equity markets are entering the Union Budget period with clear expectations of fiscal discipline and continued infrastructure investment focus. Market participants broadly anticipate the government will maintain its fiscal consolidation trajectory while sustaining capital expenditure to drive infrastructure-linked earnings growth, despite limited scope for fresh stimulus measures.

Fiscal Policy Expectations

Market experts expect a steady and disciplined budgetary approach from the government. The fiscal framework is likely to reflect the administration's commitment to medium-term debt sustainability while accommodating necessary infrastructure investments.

"The upcoming Budget is expected to take a steady and disciplined approach. We see the FY27 fiscal deficit at around 4.3 per cent of GDP, with the government remaining committed to its medium-term 50 ± 1 per cent debt-to-GDP target. Gross market borrowing is likely to stay elevated at roughly ₹16 lakh crore, reflecting heavy redemptions and a continued focus on capex," said Churchil Bhatt, Executive Vice-President – Investment, Kotak Mahindra Life Insurance.

Sectoral Investment Implications

The anticipated policy direction is expected to reinforce investor preference for infrastructure-linked sectors. Equity investors are positioning for continued public spending benefits across key industrial segments.

Favored Sectors:

• Capital goods companies
• Construction firms
• Metals industry
• Infrastructure-related stocks
• Roads and railways beneficiaries
• Manufacturing capacity builders

With committed revenue expenditure already consuming a significant portion of government receipts, economists see limited room for broad consumption-boosting measures. Instead, markets are tracking targeted support for export-oriented sectors facing global challenges, alongside incentives for manufacturing and employment schemes.

Market Outlook and Investment Strategy

"The need of the hour is to encourage both government and private sector capex. Some tax relief measures for sovereign funds investing in India could also serve as a strong catalyst. Financials and pharma remain well placed, while metals may continue to perform but are running a bit ahead of fundamentals," said Arpit Jain, Joint MD at Arihant Capital Markets Ltd.

Industry Reform Expectations

Business leaders are anticipating tax reforms focused on improving ease of doing business, particularly benefiting mid-cap companies and deal-driven sectors. Industry stakeholders are seeking comprehensive tax simplification measures.

Key Reform Areas:

• Rationalizing multiple TDS rates
• Extending R&D deductions
• Linking buyback taxation with accumulated profits
• Reducing tax disputes through clearer rules
• Encouraging corporate restructuring

"On the ease of doing business front, industry is looking for greater tax clarity and simplification, from rationalising multiple TDS rates and extending deductions for research and development, to linking buyback taxation with accumulated profits," said Abhishek Mundada, Partner, Dhruva Advisors.

Startup and Technology Sector Demands

Startup companies and technology firms are particularly focused on taxation reforms related to employee stock options and capital gains treatment. The sector is seeking policy alignment to encourage private capital investment.

"Start-ups are riskier, less liquid and demand longer holding periods — yet are taxed more harshly. Correcting this imbalance is critical to encourage private capital into India's innovation economy," said Devansh Lakhani, Director, Lakhani Financial Services.

Real estate-linked stocks may also gain attention if the Budget delivers relief measures for homebuyers, along with taxation rationalization for real estate AIFs and frameworks for asset tokenization.