Govt must be careful not to drive investors away through its greed or by imposing it in a ham-handed manner
It’s a complex situation. When you ask brokers or investors about the possible impact of a turnover tax replacing long and short-term capital gains tax, they react with anger and predict disaster. Their reasons are simple. Turnover tax, they say, will have to be paid even when transactions lead to losses, while capital gains tax is only paid on realised profit. Moreover, many large investors simply dodge short-term capital gains tax (although it is a high 30 per cent) by ‘buying’ losses from other investors for a small price. In fact, several brokers earn a good fee by helping their clients who have made hefty short-term profits to avoid paying tax, by offsetting their profitable trades by ‘buying’ them matching loss transactions.
This route usually involves ‘persuading’ tax officials to turn a blind eye to their little shenanigans, but traders claim that this is part of the overall price that they already pay to avoid harassment by tax officials.
Now look at another picture. The prospect of government introducing a turnover tax hasn’t had a negative impact on the market so far. In fact, fund managers and foreign institutional investors give you an entirely different perspective. They have lobbied so long and hard for capital gains taxes to be replaced by a turnover tax, that they don’t even dare to hope that the finance minister will pay attention to them. They repeated their plea to Mr Chidambaram when he met market intermediaries in Mumbai recently. Many fund managers however say that the turnover tax will work best if it eliminates the tax on speculative profits too.
The question is, will the turnover tax be superior to the existing system? Or will it act as a disincentive and drive away day traders who provide liquidity to the market?
The answer will depend on the form in which the tax is imposed and whether the government plans to be greedy about its collection. Investors think that a 0.1 per cent tax is excessive. Brokerage for non-delivery based transactions is as low as 0.1 per cent or less these days and the government cannot take away as much as a broker earns from every trade. Hence, a five-basis point of turnover fee is probably workable, especially since it will be collected on all transactions.
Second, if government plans to collect a turnover-based tax, investors believe that it should include speculative trading as well. Once investors are taxed on turnover (rather than profit), there should be no further tax on trading income. A fund manager says that Malaysia’s capital market turnover increased after it began to tax turnover and did away with tax on speculative income.
Turnover based tax has several advantages. It will establish complete parity between FIIs and Indian investors; and between Indian and foreign mutual funds. It will eliminate the need for investors to ‘buy losses’ and even discourage dividend stripping. There will also be little incentive for single investor mutual funds to exist. For foreign investors, the most obvious advantage is in not having to be incorporated in countries such as Mauritius, which have a double-taxation avoidance treaty with India. They also won’t have to worry all the time about government withdraw-ing such tax shelters.
More importantly, turnover tax will flush out the large chunks of black money circulating in the market and allow the government to collect tax on it. The collection mechanism will also be simple. Every broker will pay five basis points of his turnover as tax. This will also save on tax administration costs. A turnover based tax has a much better chance of success in today’s automated trading environment, which imposes stringent reporting requirements on brokers and leaves little scope for leakage.
The daily stock market volume, inclusive of derivatives trading, is conservatively in the region of Rs 10,000-12,000 crore these days. At five basis points, on Rs 10,000 crore the government will collect Rs five crore everyday and around Rs 1,250 crore on an average 250 trading days per year. The amount would be twice as high if the turnover doubles as it does whenever there is a big bull run.
On the other hand, capital gains tax (long and short) that is collected by the government is estimated by fund managers at under Rs 700 crore. No-body is quite sure what the government earns on speculative profits, but brokers insist that ordinary traders rarely report these (except top operators); and even investors who file returns and pay taxes, find ways to claim it back through refunds.
The government will also have to think about two other issues. First, how will trades in unlisted securities be taxed if short and long-term capital gains tax is abolished? Will there be a separate set of rules for these companies? That will be messy. Second, mutual fund dividends will also have to be tax-free in the hands of investors because the fund would already have paid a turnover tax on each trade.
Retail investors, especially day traders will undoubtedly resent a turnover based tax. However, they can be cajoled by ensuring that it demonstrably reduces compliance related paperwork and the scope of harassment by tax officials. In my view, turnover tax will only work if it is limited to five basis with no further tax on speculative income. If the government collects 10 basis points, as reported by the media, it would be hugely resented. It could also drive investors away from the stock market, or worse, could drive them to completely illegal cash markets. This will neither benefit the government nor the market and will create bigger problems of price distortion, manipulation and regulation.
Indian capital markets are already narrow and illiquid and day traders are extremely important for ensuring that this limited liquidity does not evaporate. While turnover tax is worth experimenting with, the government must be careful not to drive investors away through its greed or by imposing it in a ham-handed manner.