Inflation is the rate at which the prices of goods and services in an economy rise over time. It is a measure of how much the prices of goods and services have increased over a set period of time. Inflation is an important economic indicator because it can signal changes in the purchasing power of a currency.
Inflation can erode money’s power in several ways. Firstly, when inflation is higher than the rate of return on investments, it can reduce returns. This can lead to a reduced ability to accumulate wealth, as more money needs to be set aside just to maintain purchasing power. Additionally, because inflation causes prices to rise, it becomes more difficult to purchase items with the same amount of money. This can lead to a decrease in money power, as people may find it difficult to afford basic goods. Finally, inflation can also lead to decreased savings, since money will lose its purchasing power over time. All of these factors can add up to less money power over time.
What is Indexation?
Indexation is the process of adjusting the value of an asset to account for the effects of inflation. This adjustment is typically made to financial assets, such as stocks, bonds, property etc, to ensure that their value keeps pace with the rate of inflation. Indexation is used to ensure that the purchasing power of an asset remains constant over time.
Benefits of Indexation
Indexation benefit is a tax benefit that applies to capital gains such as property or investments. The indexation benefit allows individuals to reduce the amount of capital gains that is taxable by increasing the price at which the asset was purchased in line with the Retail Price Index. This increase, or indexation, is applied to the original cost of the asset before the gains are calculated and can reduce the amount of gains that are taxable.
Indexation benefit we generally get on the long-term capital gain. For debt funds, the gain is considered long-term if the holding period is of more than three years. For any immovable property, this duration is of 2 years.
How to find Cost of Index Inflation
The Central Board of Direct Taxes (CBDT) calculates the cost inflation index. You can find the CII data on the CBDT website.
Cost Inflation Index = 75% of the average rise in the Consumer Price Index* (urban) for the immediately preceding year.
A Consumer Price Index (CPI) is a measure of the average change over time in the prices paid by consumers for a basket of goods and services. It is used to measure inflation and is calculated by taking the cost of the basket of goods and services in a given year relative to the cost in a base year. The CPI is a key statistic for economists and politicians in helping to understand the real-world impact of inflation.
Historical Cost Inflation Index Data
| Sl. No. | Financial year | Cost Inflation index |
|---|---|---|
|
1 |
2001-02 |
100 |
|
2 |
2002-03 |
105 |
|
3 |
2003-04 |
109 |
|
4 |
2004-05 |
113 |
|
5 |
2005-06 |
117 |
|
6 |
2006-07 |
122 |
|
7 |
2007-08 |
129 |
|
8 |
2008-09 |
137 |
|
9 |
2009-10 |
148 |
|
10 |
2010-11 |
167 |
|
11 |
2011-12 |
184 |
|
12 |
2012-13 |
200 |
|
13 |
2013-14 |
220 |
|
14 |
2014-15 |
240 |
|
15 |
2015-16 |
254 |
|
16 |
2016-17 |
264 |
|
17 |
2017-18 |
272 |
|
18 |
2018-19 |
280 |
|
19 |
2019-20 |
289 |
|
20 |
2020-21 |
301 |
|
21 |
2021-22 |
317 |
|
22 |
2022-23 |
331 |
How Indexation Reduce Your Tax liability
Indexation benefit is the advantage that arises from reducing the tax liability of an individual or business due to inflation. This benefit is available for long-term investments, such as a long-term capital gain on the sale of an asset. The indexation benefit works by allowing the investor to adjust the purchase price of the asset for inflation, thus reducing their taxable capital gain.
For example, if an investor purchased a property for Rupees 20 Lakh seven years ago and sold it for Rupees 30 Lakh today, they would normally owe taxes on the 10 Lakh capital gain. This capital gain can be reduced with the help of Indexation. First, we need to find the Indexed Cost of Investment, which include the effect of inflation.
Indexed Cost of Investment= 2000000* (CII for the Year of Selling/CII for the Year of Purchase)
= 2,000,000*(317/240) = ₹2641,666
Now we will calculate the capital gain from the Indexed Cost of Investment which is calculated below.
Capital Gains with Indexation = 3,000,000 – 2,641,666 = ₹358,333
Tax will be based on the new LTCG which we have calculated from indexation.
Tax with Indexation = 20% of 358,333 = ₹71,666
Tax without Indexation (20% of 1,000,000) = ₹200,000
*Long Term Capital Gain Tax Rate of 20%
Actual profit (With indexation) = Sale price – purchase price * (CII for the year of selling / CII for the year of purchasing)
| Sr. No | Particulars of Property | Units | Amount(INR) |
|---|---|---|---|
|
a |
Buying Price |
|
₹20,00,000 |
|
b |
Selling Price |
|
₹30,00,000 |
|
c |
Cost Inflation Index |
|
|
|
d |
CII for the Year of Purchase (2014-15) |
240 |
|
|
e |
CII for the Year of Selling (2021-22) |
317 |
|
|
f |
Indexed Cost of Investment |
|
₹26,41,666 |
|
g |
Capital Gains Calculation |
|
|
|
h |
With Indexation Benefits (Indexed Cost) (b-f) |
|
₹3,58,333 |
|
i |
Without Indexation Capital Gain (b-a) |
|
₹10,00,000 |
|
j |
With Indexation (h*20%) |
|
₹71,666 |
|
k |
Without Indexation (i*20%) |
|
₹2,00,000 |
|
NOTE |
Long-Term Capital Gain Tax Rate |
|
20% |
Words of Wisdom
“Never spend your money before you’ve earned it.” ― Thomas Jefferson
Key Takeaways
- Indexation is employed to maintain the real value of an investment or asset by adjusting its cost basis to reflect changes in the general price level due to inflation.
- Indexation helps in reducing capital gains tax on various investment assets like Bonds, Property etc.
- Indexation is typically relevant for long-term capital gains, as short-term gains are usually less affected by inflation over a short period.
Conclusion
Indexation is a valuable tool for investors as it helps them mitigate some of the effects of inflation. Indexation is used to ensure that the purchasing power of investments does not diminish over time and helps to preserve wealth. It also provides a measure of diversification when investing in markets, as well as reducing portfolio volatility and providing a hedge against inflation. As such, indexation has become an important part of the investment landscape and is used by both institutional and retail investors.
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