Fundamental factors

FPI taxation and capital flows should not be mixed

Despite the recent pullback in equity markets, considerable anxiety exists among retail investors, including those investing through mutual funds in a disciplined manner using systematic investment plans. The benchmark Nifty 50 is down about 9 per cent since the beginning of this year and is flat since January 2025. Persistent selling by foreign portfolio investors (FPIs) is one reason for this underperformance.  FPIs this year net sold Indian stocks worth about ₹2.9 trillion and were net sellers in 2025 too. This has led to demands that taxes on them should be reconsidered. The argument is that most jurisdictions don’t tax foreign investors, which tends to affect the capital-allocation decisions of large international fund managers. 

In this context, Union Finance Minister Nirmala Sitharaman, during an interaction this week, acknowledged the concern over sustained FPI selling. However, the minister rightly pointed out that the tax structure was the same when India received robust capital inflows in 2023-24. No changes had been made to attract capital flows. She did acknowledge that the circumstances had changed since then. It has been reported that the Securities and Exchange Board of India (Sebi) has also recommended removing long-term capital gains (LTCG) tax imposed on foreign investors. Given that the tax is not affecting market functioning in any manner, it is intriguing why Sebi is making such suggestions. Perhaps the market regulator is conveying its gleanings from conversations with FPIs and stakeholders. Be that as it may, the issue is worth debating. The outflow clearly has not happened because of taxes. It is worth highlighting that FPIs are buying too — it is just that the amount of selling is higher in the aggregate. For instance, FPIs have been net buyers thus far in November’s two days of trading, and were net buyers through July and August. 

For policy purposes, the issue of recent FPI flows must be separated from that of taxation. Outflows are being driven by more fundamental factors, with implications for macroeconomic management. Risk capital from across the world is being invested in a big way in artificial intelligence (AI) and related areas. Since India is not a large player in AI, it is finding it difficult to attract foreign capital. The other reason is the significant increase in government bond yields across the world. An increase in the risk-free rate tends to push up the asking rate of return for other assets. These, along with higher oil prices owing to the conflict in West Asia, are putting pressure on the balance of payments and, consequently, the rupee. 

Thus, the macroeconomic response to the situation needs to be much wider. The Reserve Bank of India (RBI) attracted foreign flows under swap schemes, including one for Non-Resident Indians. The data suggests that it is using its reserves to contain the decline in the rupee. The RBI has also put various restrictions in the currency-derivatives market to curb volatility. However, these measures will work if global conditions are expected to turn favourable soon. If the underlying conditions persist for a few more months, macroeconomic management could become more challenging. A lot will depend on how the results of the midterm elections in the United States influence its actions in West Asia. On the issue of taxation, since India needs robust capital flows in all circumstances to supplement domestic savings to achieve higher economic growth, its policies should not be out of sync with the rest of the world. The government will have to consider various other aspects, such as taxing different instruments for resident investors. Ideally, differential tax treatment should not influence investment decisions unless that is the desired policy objective.