The market could learn to live with a five basis points turnover fee without too much damage
At 9.40 am on Friday, just before stock markets opened for trading, the Securities and Exchange Board of India chairman, GN Bajpai, made an unusual appearance on television channels. He asked investors not to panic, since transaction tax wouldn’t be applicable until the Parliament passed the Finance Bill. He also said that he would help brokers represent their case to the finance minister.
These statements seemed to suggest that there was scope for reconsidering the transaction tax. The impact was immediately apparent on Friday’s trading. Investors stopped selling, while buying support from Indian and foreign institutions gradually pushed up prices until the Bombay Stock Exchange Sensex closed 101-points higher than on budget day in a day of very low trading volumes.
Immediately, traders turned foolishly confident that transaction tax would be rolled back. They think that the need to correct gross blunders in connection with the taxation of equity mutual funds and debt market transactions has created an opportunity for withdrawing the transaction tax altogether.
Senior finance ministry officials however assert that the transaction tax was levied with proper consideration and international comparisons. How then do they explain the debt market goof up where spreads are wafer-thin; or, the confusion over capital gains tax payable by equity mutual funds, or even the ignorance about high taxes already paid on speculative profits? Levying transaction taxes on the strike price of options trades is bound to kill that fledgling business — how was this justified inside North Block?
Incidentally, listen to what a paper on Securities Transaction Taxes and Financial Markets by Karl Habermeier and Andrei A Kirilenko of the International Monetary Fund (IMF) has to say. This paper argues that transaction taxes can have negative effects on price discovery, volatility, and market liquidity in securities markets. These effects can lead to a reduction in market efficiency and may contribute to increased asset price volatility.
Clearly, there are varied views on the effect of transaction costs and some correction is in order. The finance minister’s post-budget interviews also seemed to indicate that he was willing to listen. It seems to me that a complete withdrawal of transaction tax may be difficult, and it does indeed have several advantages.
But the government needs to revisit the basic objective in levying transaction tax in order to find a fair solution. If the objective was merely to raise direct taxes collected from the investor community from the level of Rs 700-odd crore (through capital gains tax) to a huge Rs 4,000 crore, then the capital market is set to stagnate and switch over to illegitimate trading avenues.
But if the objective was to create a level playing field between Indian and foreign institutional investors, encourage non-resident Indian investment, find a way to tax black money, reduce corruption and to achieve all this through a simple transparent mechanism, then some key changes must be made.
But first, the finance minister needs to understand the business of stock trading, its high risks and the fact that losses often exceed profits. Revenue estimates cannot be based on 12 months’ of buoyancy. When the stock market goes through its periodic bear phases, both investors and day-traders disappear and brokers are forced to shrink operations. Frequent scams and market manipulation have also ensured that the capital markets remain a dangerous place. This is why India’s investor population hasn’t grown beyond two crore in over a decade. Day traders/punters/scalpers form a small portion of this population, but their presence is critical because their continuous churning of stock provides liquidity to the market and keeps trading turnover high.
Mr Chidamba-ram, in presenting a budget that is valid for just seven months, could have been more cautious about the quantum of transaction tax levied instead of triggering chaos. Some economists, who have the FM’s ear, mentioned a one basis point tax on derivatives trades and two basis points on cash market transactions. Other market intermediaries who met him individually before the budget also say that they had rooted for a similar number.
After speaking to a variety of market intermediaries, I believe that the market could learn to live with a five basis points turnover fee without too much damage. However the key, as this column had discussed a few weeks ago, is in simultaneously eliminating all other taxes pertaining to capital market transactions. The short-term capital gains tax of 10 per cent will have to go and speculative income cannot be treated as business income, subject to 33.6 per cent tax (as is applicable today to profits from intra-day trading and derivatives trading).
Some sources argued that the government may be unwilling to reconsider the tax on speculative transactions. But clearly, a 15 basis points transaction charge on a segment that imparts much-needed liquidity to the market, in addition to 33.6 per cent income tax is unfair. It also militates against the objective of making the process of paying taxes clean, simple and transparent.
If the FM is worried about losing revenue by giving up on this 33.6 per cent tax, he needn’t worry. Many investors simply offset high speculative profits by “buying losses”. This manipulation costs them anywhere between three to six per cent and is significantly lower than the tax they would have paid. So real losses may be insignificant.
The biggest danger in the government refusing to reconsider the extent of transaction tax is that it will drive traders out of the market. The consequence would be the re-emergence of bucket shops and ‘dabba’ traders, who will happily grab the business. The FM would recall that raids against ‘dabba’ traders conducted by SEBI and stock exchange authorities a year ago revealed extremely sophisticated systems that accurately aligned transactions and settlement prices to the official stock exchanges. This was done by trading just a single share on the official bourse for a price benchmark.
Such shops will re-emerge. And the very objective of catching all transactions, including unaccounted money will be badly defeated. Instead, we will have a shallow and illiquid market that will not even interest the same institutional investors who lobbied for turnover tax.