The Nifty 50 has fallen more than 6% since the unexpectedly high April–June 2026–27 GDP numbers were released four weeks ago. Two primary reasons are offered for this, both of which pin the blame on external factors that render India helpless: the US–Iran conflict and the world’s fascination with AI. The conflict hurts the economy, and the absence of an AI play makes Indian equities unattractive.

But a domestic policy factor also comes into play at times like these.

Each time the stock market tanks (and a run of seven straight weeks of losses is almost unprecedented), the conversation shifts towards taxation of equity investments. On cue, market maven Nilesh Shah called for “some sort of equilibrium between STT and capital gains” on Monday. He was, of course, referring to a long-standing pain point for investors, who pay securities transaction tax each time they buy or sell securities and pay capital gains tax on any gains from a sale.

Reinforcing the policy argument is the fact that Indian equities have lagged markets in countries of all hues, developed and developing, including those with no AI trump cards.

Of course, we need to distinguish between the factors driving a market slowdown and the costs that make it harder for investors to navigate it. Tangible reasons for the lag go beyond tax policy, including weak earnings growth, high valuations relative to other markets, low foreign investor interest, adverse currency movements, the pace of reforms, and more.

Moreover, several experts argue that both domestic and foreign investors were fine with tax policy earlier. But that’s the point: when returns are scarce, every leak hurts, more so when you consider that foreign institutional investors have to pay tax on rupee gains, making their net dollar returns even more meagre at a time when other markets are both more welcoming and more rewarding. Tax burdens only exacerbate concerns over high relative valuations, poor earnings growth prospects, and currency risk.

Thus, in the analysis of the reasons for this severe lag in returns, tax policy doesn’t get its due in all the hand-wringing.

Some historical context helps explain why.

Warped Policy

STT was introduced in 2004, replacing long-term capital gains tax on equities.

The 2004 reform was considered seminal, a pact between the government and investors: the emphasis was on taxing regular trading rather than the accumulation of long-term savings. Plus, there were clear and compelling reasons not to tax such long-term capital gains, since such investments encourage financialisation, build up long-term savings, and channel them into productive endeavours.

The pact was broken in 2018 when taxation of long-term gains was reintroduced without removing STT. This is the disequilibrium between STT and capital gains that Shah referred to, and his call for balance is a fair ask given the history and where markets are.

If anything, the policy stance got worse in 2024. With few growth levers and new spending compulsions, a constrained Union government went for the lone bright spot: the stock market.

Tax Squeeze

Cut to July 2024, when the present government presented its first Union Budget. The slump in consumption and private capital expenditure was an almost acknowledged reality, and expectations of a stimulus to lift markets ran high, but nothing of the sort happened.

What did happen was that, left with no other cash cow to milk, the government went after the one that was still productive, the stock market.

In the Budget, the government significantly increased the STT and short-term capital gains tax rates, ostensibly to curb rampant speculation. What beggared belief then was the increase in LTCG tax on equity sales from 10% to 12.5%, just when long-term investors were looking for a break.

Recall that markets peaked about two months after that Budget and have tottered since then. While tax policy is surely not the reason for this fall, it does weaken sentiment, which contributes to lower market interest and, in turn, lower returns.

This is now weighing heavily on investor sentiment because, in good times, everyone overlooks minor inconveniences like taxes. When returns dwindle, such policy bites disproportionately. Plus, there’s a genuine grouse, as stated earlier, that STT was not only retained despite the reintroduction of LTCG tax but was also increased.

All this has caught up now that returns have dried up and foreigners are no longer enamoured of Indian equities. Cash-rich domestic institutional investors continue to provide FIIs with exits, even as they sit on negative returns. Retail investors and traders keep losing. Only one entity makes money, and a lot of it, even in these dull times: the government, as seen from the tax collection numbers.

In almost every year since 2018, when the LTCG tax was reintroduced, growth in either STT or LTCG tax collections (in many years, both) has far exceeded benchmark equity returns. How is this growth in collections possible when equities have been stuck in a rut for over two years?

STT is a tax on transactions, not on gains. So as long as people trade, whether to speculate or run their households, the government makes money even if these trades lead to losses. And turnover has continued to climb since the pandemic, despite multiple SEBI interventions to restrict speculative trading, especially in futures and options.

Similarly, with tax on long-term gains reintroduced in 2018, a fair amount of accumulated gains is subject to tax despite the recent stagnation in equity prices. Besides, investors’ typical holding period is shorter than the eight years since the grandfathering of gains.

The 2024 Budget proposals also helped: STT and LTCG tax collections grew 55% and 79%, respectively, in 2024–25, despite a modest 6.2% gain in the frontline index that year. This was mostly thanks to higher tax rates.

The end result is that no one is happy. A recent report by Bernstein says FIIs do not see positive macroeconomic data as a strong enough reason to invest heavily. Meanwhile, with its tax policies, the government is, ironically, bleeding the same retail investor that it proudly counted as a reliable cushion against fickle FII investment.

This is showing up in the numbers. A SEBI report from August 2026 shows that the number of active individual traders declined by about 20%, from 9.81 million in 2024–25 to 7.86 million in 2025–26, while the number of new entrants declined by about 40%, indicating moderating retail participation. At the same time, the NSE’s active client base dropped 7% in 2025–26 to 45.7 million.

There may not be much left to milk soon.