Does the imposition of tax on equity funds LTCG make a difference in my choice between equity funds and debt funds?

At a very fundamental level, one can argue that equity funds and debt funds are not exactly comparable as they are different products altogether and are meant to address a different set of goals. Typically, debt funds are mapped to short to medium term goals while equity funds are mapped to long term goals like retirement, child’s education etc. The real point to note is that debt funds get the benefit of indexation while equity funds do not. How does that change the equation? Let us look at a live illustration with a five year time frame.

It is clear that despite the LTCG tax and having to live without the benefit of indexation, equity funds are still doing better than debt funds. While the equity fund has still done better than the debt fund in post tax terms, the LTCG benefit of equity funds is diminishing. Here are 2 points that one needs to remember quite distinctly:

Firstly, the above equation would have been strongly weighted in favour of equity funds had the 10% tax on equity fund LTCG not existed. That has largely taken away the tax attractiveness of equity funds vis-à-vis debt funds in the long run. In relative terms, this move has worked in favour of the debt funds vis-à-vis equity funds.

Secondly, for the sake of simplicity, we have assumed that the equity fund and the debt fund generate the same return, which is not the case in reality. The message is that now equity funds will have to sharply outperform the debt fund returns to compensate for the loss of tax benefits on equity funds. High risk in equity funds needs to actually translate into higher returns to be able to justify the post tax returns. To cut a long story short, while equity funds still remain the best way to generate wealth in the long run, this 10% tax on LTCG has surely taken some charm away from the tax benefits of equity funds. That is something equity fund investors need to watch out for.