A Budget for Capital Formation, Not Just Fiscal Bookkeeping

As India approaches another Union Budget, the familiar rituals will resume: deficit targets debated to the decimal point, fiscal glide paths defended, and spending announcements calibrated for visibility. What this theatre obscures is a more consequential question. For an economy that remains capital-deficient relative to its growth ambitions, the real policy choices lie not in how much the state spends, but in how savings are taxed, long-term capital is mobilised, and financial risk is distributed across balance sheets.

India does not suffer from a lack of credit demand. What it faces instead is a widening mismatch between rapid credit expansion and the mobilisation of stable, long-duration savings and foreign capital. Credit growth continues to outpace deposit growth, pushing banks toward bulk deposits and market borrowings. Capital markets are increasingly expected to perform maturity transformation by default. 

This imbalance becomes most visible during episodes of global risk aversion, when foreign capital retreats and pressure builds simultaneously on equity markets, bond yields, and the rupee. The Budget offers an opportunity to address these fault lines, not by doing more, but by intervening less in the wrong places.

The reintroduction of long-term capital gains tax on equities in 2018 was defensible in its context. Markets had delivered sustained gains, participation was broadening, and exemptions appeared anomalous amid post-GST revenue uncertainty. Taxing realised equity gains was framed as equitable and fiscally prudent.

That context has changed. Equities are no longer peripheral assets held by a narrow segment of households. They are actively promoted as vehicles for household wealth creation and as conduits for domestic capital formation. At the same time, India is far more integrated into global capital flows. Episodes of foreign portfolio investor selling, driven by global interest rates, dollar strength, or risk repricing—now transmit rapidly into domestic markets and the exchange rate.

In this environment, the cumulative tax burden on equity capital matters. LTCG taxation, combined with securities transaction tax, raises the effective cost of participation for both domestic and foreign investors. For FPIs, this interacts directly with currency risk. When post-tax returns are compressed by transaction costs and the rupee is under pressure, the incentive to remain invested weakens further. The result is a familiar feedback loop: outflows pressure the currency, currency weakness amplifies return uncertainty, and markets become increasingly dependent on episodic policy support.

For a capital-scarce economy, taxing the normal return on long-duration risk capital is not neutral policy. It discourages precisely the patient capital that absorbs shocks and stabilises markets. Rationalising LTCG for genuinely long-term holdings, alongside a reassessment of STT on delivery-based transactions, would not be a concession to markets. Why not also ban zero day options or subject them to higher STT? It would recognise that the duration and stability of capital matter as much as headline inflows. When patient capital is taxed like speculative churn, investment horizons shorten and volatility becomes more damaging.

Savings Paradox
A similar contradiction is visible in the treatment of household savings. Taxing even modest savings-bank interest beyond basic thresholds reflects outdated assumptions about surplus domestic savings. In reality, deposit mobilisation lags credit growth, while real returns on simple savings instruments remain compressed. Policy signals that penalise low-risk savings nudge households either towards consumption or towards volatile market-linked products, often without adequate buffers. Weak domestic savings, in turn, deepen dependence on foreign capital and heighten vulnerability to global cycles.

This weakness is compounded by the absence of a coherent gold policy. India remains structurally import-dependent for gold and silver, and rising global prices worsen the current account precisely during periods of financial stress. Yet households hold vast quantities of gold outside the formal financial system. Policy has oscillated between punitive import duties and episodic financialisation schemes, achieving neither stability nor mobilisation.

Treating gold merely as a consumption vice ignores its macroeconomic role. A credible, stable framework that encourages voluntary monetisation and financial substitution would reduce external vulnerability and expand the domestic pool of long-duration savings without fiscal cost.

The failure to mobilise stable savings is even more evident in insurance and pensions. India’s insurance penetration and pension coverage remain low for an economy of its size and demographic profile. Yet these institutions generate precisely the kind of countercyclical, long-duration capital the system lacks—capital that does not exit at the first sign of global stress. Policy has too often treated insurance premia and pension contributions as narrow tax-base items rather than macro-financial stabilisers.

None of this requires abandoning the new tax regime. Its promise of lower rates, fewer exemptions and simplicity is sound. But it rests on an implicit assumption that savings, insurance, and pensions are discretionary consumption choices. They are not. Consumption-linked exemptions can be withdrawn with limited harm; capital-formation instruments should be treated differently. LTCG rationalisation lies outside the slab structure altogether. A modest, uniform threshold for savings interest functions as a de minimis rule, not a distortion. Long-term savings incentives can be redesigned as neutral, capped credits available under both regimes, conditional on lock-ins rather than product labels.

If easing taxation on long-term capital and savings entails near-term revenue trade-offs, those must be addressed transparently. The answer lies in taxing rents rather than returns, modernising property and land taxation, improving compliance in services and professional incomes, monetising underutilised public assets, pursuing long-delayed privatisation of a core or peripheral public sector bank, and undertaking a serious rethink on wealth taxation. Beyond one-off proceeds, such steps would reduce recurring recapitalisation demands and signal that financial-sector reform is directional rather than episodic.   

Perhaps the most persistent distortion in India’s financial architecture is the expectation that banks can absorb fiscal and policy risks by default. This is most evident in the MSME segment. Instead can there be a tax holiday for MSMEs within certain threshold parameters and requisite guardrails? Fiscal policy should bear fiscal risk; banks should be allowed to price credit risk honestly.

This Budget should not be judged by the elegance of its arithmetic, but by the intelligence of its restraint. For an economy seeking rapid growth without recurring balance-sheet stress or chronic dependence on volatile foreign flows, the priorities are clear: encourage saving, reward duration, mobilise inert capital, reduce friction on long-term risk-taking, and tax rents—not the foundations of capital formation.