As Budget 2026 approaches, market veterans are expressing serious concerns about India's capital gains tax structure, warning that the substantial gap between equity and debt taxation is creating investment distortions with broader economic implications. The current tax framework significantly favours equity investments over fixed-income instruments, potentially undermining the stability of traditional funding sources.

Current Tax Structure Creates Investment Imbalance

The existing tax regime presents a stark contrast in treatment across asset classes. Key aspects of the current structure include:

G Mahalingam, former Executive Director at the RBI and former Whole-Time Member of SEBI, highlighted that while the government uses tax incentives to encourage financial market participation, the current disparity may be excessive. He noted that equity investments carry significantly higher risk compared to bank deposits and bonds, yet the tax treatment creates strong incentives for risk-taking without adequate consideration of underlying risks.

Expert Concerns on Risk-Return Dynamics

Ananth Narayan, former Whole-Time Member of SEBI, emphasized that taxation has become a primary driver of asset allocation decisions in India. This tax-driven approach is pushing even conservative investors like pensioners and retirees toward higher equity exposure to protect their savings from inflation.

Narayan pointed out a critical issue with fixed-income taxation: when investors earn approximately 6% returns while inflation runs close to 5%, they are effectively being taxed on capital rather than real income. He argued that fixed-income investments also carry interest rate risk and credit risk, making it unfair to tax the entire interest income at marginal slab rates.

Macroeconomic Implications for Banking Sector

Mahalingam warned that the current tax imbalance could create significant macroeconomic problems. The shift of investor funds toward equities is contributing to weak growth in bank deposits, creating funding challenges for the banking sector.

This deposit shortage has particular implications for credit distribution:

• Large corporations: Can access bond and equity markets for funding
• MSMEs: Remain heavily dependent on bank loans
• Credit risk: Deposit shortages could constrain MSME lending

Market Evolution and Policy Context

Srinivasan Varadarajan, Banking Veteran and Market Expert, provided historical context, noting that policymakers initially used tax incentives to attract equity capital when India faced capital shortages. However, the investment landscape has transformed significantly over the past decade, with equity participation surging and investor numbers rising sharply. Equity mutual fund assets have now overtaken debt funds, indicating a fundamental shift in investment patterns.

Recommendations for Tax Reform

Experts are calling for a more balanced approach to capital gains taxation. Narayan advocated for uniform and low long-term capital gains tax across asset classes, which would allow investors to allocate savings based on risk appetite rather than tax considerations. This approach could help restore balance to investment flows and support more stable funding for different sectors of the economy.

The concerns raised by these market veterans highlight the need for careful consideration of tax policy impacts on broader economic stability and credit availability, particularly for sectors dependent on traditional banking channels.