Inflation erodes the purchasing power of money over time. In simple terms, the same amount of money will buy fewer goods or services in the future.
Indexation is a powerful tool to estimate purchasing power changes and adjust against inflation levels. It is a beneficial method for investors to estimate the actual loss or gain on their investments.
This post will help you explore this powerful tool of indexation, benefits & calculation method. So, let’s get started!
Inflation & Purchasing Power of Money
Inflation refers to the general increase in the prices of goods and services over time leading to a corresponding decrease in the value of money. Hence, Inflation & purchasing power of money are interconnected concepts.
What Is Indexation?
Indexation is a helpful method of adjusting the value of a financial asset or liability to preserve the purchasing power of the asset that may be eroded by inflation.
Earlier, investors used this powerful tool to lower their tax liabilities on debt mutual funds. However, with the recent changes in taxation rules, new investors can not leverage indexation w.e.f. 1 April 2023.
How to calculate Indexation
Every year, the government issues CII (Cost Inflation Index) that represents the inflation for that particular year. By using CII, anyone can calculate indexation. For calculation, you need the following.
- The original cost of the asset
- The cost inflation index (CII) for the year of purchase
- The cost inflation index (CII) for the year of sale
Put these details in the following formula to calculate indexation:
Indexation = [Original cost of acquisition ✖ CII of the given year] / CII of the base year
Example: You invested ₹ 5,00,000 in a debt mutual fund in 2015 and sold it for ₹ 8,00,000 in 2020. The CII for 2015 is 254 and for 2020 is 301.
Indexation = [5,00,000 X 301 ] / 254
= ₹ 5,92,520 approx
Indexed Capital Gain: Sale Price – Indexed Cost
= ₹8,00,000 – ₹592520
= ₹ 2,07,480
It means the tax will be calculated on ₹ 2,07,480 & not on ₹ 3,00,000.
Use Cases Of Indexation
In the financial context, indexation has numerous practical applications that help us in the following cases:
1. Calculating gains on investments
When you sell your investments, you are subject to capital gain taxes. Indexation ensures that you are taxed on the real gain in value by adjusting the purchase price of the asset to account for the impact of inflation over the holding period.
2. Estimating real return on investments
On the one hand, your investment is growing at a good rate. On the other hand, inflation is eating on the growth of your assets. Indexation assists you in estimating how much real return you gain on your investments.
3. Determining the inflation rate
Indexation plays a vital role in tracking & determining the inflation rate. By using indices such as CPI (Consumer Price Index), we can measure the changes in the cost of a basket of goods and services over time.
4. Adjusting amounts to keep pace with inflation
We know that inflation erodes the purchasing power of money. Hence, it can impact long-term contracts or agreements. To ensure fairness & alignment with changing prices, indexation is employed.
Here are some benefits of Indexation:
A. Accurate Measurement of Performance: Due to inflation, you can not measure the actual growth of your investments. However, it is possible with the help of indexation.
B. Protects Against Inflation: If you are quite aware of inflation, you can protect yourself against inflation with the help of indexation & early planning.
C. Reduces Tax Liability: In investment schemes with indexation benefits, investors can reduce their tax liabilities. Indexation helps in estimating the actual gains & consequently, the applicable taxes.
D. Fairness and Equity: Indexation promotes fairness and equity by adjusting tax brackets, exemptions and deductions to account for inflation.
Here are some limitations of indexation:
A. Limited Applicability: Indexation benefits may not be applicable to all types of investment instruments. The availability of indexation may be subject to various rules and regulations.
B. Not Effective In All Cases: While indexation is generally useful, its effectiveness may be limited in cases of high inflation. The accuracy of the calculations may be compromised in such situations.
C. Limited Impact on Short-term Investments: Indexation primarily benefits long-term investments, while its impact on short-term investments is minimal.
How can individuals and businesses apply indexation in their financial decision-making?
Individuals and businesses can apply indexation for the following:
1. Capital Gain Tax Planning
2. Investment Analysis
3. Long-term Financial Goal Setting
4. Pricing & Cost Estimation etc.
What are the potential risks or drawbacks of relying solely on indexation?
Here are the potential risks of relying solely on indexation:
1. Variation in inflation rate
2. Calculation errors
3. Inaccurate reflection due to inaccurate resources etc.