Budget 2026: Can Tax Reforms Halt India's FPI Outflow?

Introduction: A Critical Juncture for Indian Markets

The Indian equity market stands at a critical juncture as it contends with sustained capital outflows from Foreign Portfolio Investors (FPIs). With a staggering ₹2.40 lakh crore withdrawn in 2025 and another ₹38,740 crore shed in January 2026, the pressure is mounting on policymakers. All eyes are now on the upcoming Union Budget 2026, which is widely seen as a pivotal opportunity for the government to introduce measures that can restore foreign investor confidence and reverse the selling trend that has left FPI equity holdings at a 15-year low.

The Scale of the FPI Exodus

The flight of foreign capital has been significant. FPIs pulled out ₹19 billion in 2025, followed by another ₹4 billion in January 2026. This consistent selling pressure contributed to the Nifty 50 index recording its weakest January performance in over a decade, with a decline of 3.10%. The outflow is attributed to a combination of factors, including a global capital rotation towards AI-centric markets like the United States, Taiwan, and South Korea. Additionally, a weakening Indian rupee, geopolitical uncertainties, and elevated US bond yields have made risk-free assets in developed economies more attractive, diminishing the post-tax returns from Indian equities.

Identifying the Tax 'Irritants'

Market experts have been vocal about the specific policy hurdles deterring foreign investment. Arvind Sanger, Managing Partner at Geosphere Capital Management, identified the tax charged at the fund level in India as a 'punitive' and 'uniquely an Indian problem'. He explained that this structure leads to double taxation for investors from countries without a tax avoidance treaty, as they are taxed once in India and again in their home country. Sanger also highlighted concerns over retroactive policy changes, citing a recent Supreme Court decision on back taxes as an example that erodes investor confidence by creating uncertainty about the stability of the regulatory framework.

The Debate Around Capital Gains Tax

A central point of discussion ahead of the budget is the rationalisation of the capital gains tax regime. Currently, Long-Term Capital Gains (LTCG) on listed equities held for over 24 months are taxed at 12.5%, with an exemption up to ₹1.25 lakh. Market expert Sudip Bandyopadhyay suggested that removing the LTCG tax would be a significant positive surprise that could contain FPI outflows. Other recommendations include increasing the exemption limit to ₹2 lakh or lowering the tax rate back to 10%. While a complete removal of the Securities Transaction Tax (STT) is considered unlikely, any move to rationalise capital gains taxation is expected to be cheered by the market.

Policy Stability and Economic Fundamentals

Beyond specific tax rates, the broader message from experts is a call for policy stability and continued supply-side reforms. Sanger noted that the Union Budget has become less of a single, major event, with significant reforms now occurring throughout the year. The focus, he argued, should be on creating a predictable environment that encourages long-term growth, even if it requires some short-term fiscal flexibility. This sentiment is echoed by investors who value fiscal prudence and a clear divestment strategy from the government to manage resource constraints effectively.

India's Positioning in the Global Market

Another challenge for India is its perception as an 'anti-AI trade'. As global capital chases the boom in artificial intelligence, markets with strong technology and semiconductor industries have benefited. Sanger cautioned against the assumption that foreign investors have no alternative to India, pointing out that markets in Korea, Taiwan, and even China are seen as beneficiaries of the AI cycle. This underscores the need for India to strengthen its own growth fundamentals rather than relying on periodic unwinding of global trends.

Domestic Resilience Amidst Foreign Outflows

While FPIs have been selling, the Indian market has found a crucial pillar of support in its domestic investors. A consistent flow of capital into mutual funds has provided a cushion against foreign outflows. The mutual fund industry is reportedly sitting on approximately ₹1.9 lakh crore in cash, representing a significant source of domestic liquidity. This resilience has prevented a sharper market correction, though the defensive positioning of FIIs—evidenced by aggressive short positions on index futures—indicates continued caution from foreign players.

Economic Outlook and Budget Expectations

The economic backdrop for the budget is mixed. The Economic Survey 2025-26 projects a robust real GDP growth of 7.4% for FY26, positioning India as a leading global economy. Inflation has also moderated. However, the balance of payments (BOP) showed a deficit of $1.4 billion in the first half of FY26, a stark contrast to the surplus a year earlier. The government's ability to stick to its fiscal consolidation path while introducing growth-oriented, investor-friendly policies will be the key determinant of market direction. Targeted relief for FPIs, a clear divestment roadmap, and continued focus on infrastructure and defence are among the key expectations.

Conclusion

The Union Budget 2026 is more than just an annual financial statement; it is a critical opportunity to reset the narrative for foreign investment in India. While a reduction in the LTCG tax would be a welcome signal, the larger challenge is to address the structural irritants and policy uncertainties that have prompted the recent capital flight. By fostering a stable, transparent, and competitive tax regime, the government can work to halt the FPI exodus and reaffirm India's position as a compelling long-term investment destination.