Simplifying (Stocks + Inflation + Tax)
Diving into mutual funds can be intimidating due to the associated risk, but many take the leap compared to parking funds in a fixed deposit as the returns are higher.
However, the most important factor, which isn’t widely advertised and might sound alien to many, is claimed to be indexation.
Quoting Cleartax on indexation,
Indexation is used to adjust the purchase price of an investment to reflect the effect of inflation on it
This definitely sounds enticing given that an important reason for investments is to prevent inflation from eating our returns. But is it as good as it sounds?
ET provides a simple example of how indexation works in action.
Investment — Rs. 1 lakh
Return after 3 years — Rs. 1.4 lakhTo adjust for indexation, one requires CII — cost inflation index
The mathematical formula to inflate the purchase price is:
Indexed cost = (CII for the year of sale/ CII for the year of purchase) X (Cost of purchase)
That means, in our example, it would be:
Indexed Cost = (1125/852) X (Rs 1 lakh) = Rs 1,32,042
As you can see, the calculation helped you to inflate your purchase price to Rs 1,32,042 from Rs 1 lakh giving a difference of only Rs. 7,958 subjected to tax.
The corresponding tax is
20% of Rs. 7,958 = Rs. 1,592
instead of
10% of Rs. 40,000 = Rs. 4,000 without indexation
The example shows concrete benefits for indexation, but an important thing to note is the benefits strongly depend on the rate of return.
One can obtain a simple expression for where the balance shifts between the two tax options or put concisely, the inflection return, by comparing compound returns between them. Note that using indexation increases the percentage to 20 but reduces the amount to be taxed.
Using algebra, one obtains the inflection return as
To compute this and get better insight, I decided to use the entire range of current CII data which starts in 2001.
The following table assumes you’ve made your investment starting 2001.
+---------+-------------------+
| Year | Inflection Return |
+---------+-------------------+
| 2002-03 | 10.00 |
| 2003-04 | 8.63 |
| 2004-05 | 8.01 |
| 2005-06 | 7.59 |
| 2006-07 | 7.57 |
| 2007-08 | 7.92 |
| 2008-09 | 8.23 |
| 2009-10 | 8.78 |
| 2010-11 | 9.91 |
| 2011-12 | 10.36 |
| 2012-13 | 10.50 |
| 2013-14 | 10.74 |
| 2014-15 | 10.82 |
| 2015-16 | 10.57 |
| 2016-17 | 10.18 |
| 2016-17 | 9.51 |
| 2017-18 | 9.16 |
| 2018-19 | 8.85 |
+---------+-------------------+Using indexation for tax benefits makes sense only when the return rates are lower than inflection.
Large-cap and small-cap mutual funds comfortably average in double digits over long-term and thus the whole idea of indexation seems like a consolation prize for recent historical data.
Is this trend likely to remain true in the future? Yes (with all others equal)
