Aug 02nd 2004, Parthapratim Pal

The Securities Transaction Tax (STT) or the turnover tax introduced in the Union Budget for 2004-05 has been a controversial move. As an immediate impact of the announcement of the STT, there was more than a hundred point drop of the Bombay Stock Exchange sensitivity index (Sensex). Though the Sensex partially recovered subsequently, the threat of imposition of the turnover tax led to protests by the brokers of stock exchanges all over India. As a fallout of these protests, on 21st July 2004, the Finance Minister amended his proposals by significantly lowering the tax burden and by proposing a new STT regime with different tax rates for different types of securities. Though this amendment has made the stock market and day traders happy, it is likely to result in significant revenue losses for the government. Estimates suggest that the new STT will lead to a revenue loss of Rs 6,000 to Rs 6,500 crores for the fiscal year 2004-05. Given the fiscal constraints faced by the government, it is difficult to understand the rationale behind this tax rollback. Moreover, as discussed in more detail later, the new STT is more lenient towards non-delivery based short-term trading and there is a possibility that it will encourage speculative noise trading activities in the stock market.

To put things into perspective, the imposition of STT was not an isolated change. It was accompanied by major reduction in the capital gains tax rate. The finance minister proposed to abolish the current 10 percent tax on long-term capital gains from securities transactions. In the case of short-term capital gains from securities, he proposed to reduce the rate of tax to a flat rate of 10 per cent . Currently, short term gain is aggregated with taxable income from other income classes and the short term capital gains tax is levied at personal income tax rates. Against these reductions in capital gains tax, he proposed to impose the STT on transactions in securities on stock exchanges. This tax was proposed to be levied at the rate of 0.15 per cent^[1] of the value of the security and would be payable by the buyer of the security.

The benefits for imposing such a turnover tax, in lieu of capital gains tax, are manifold. As Singh (2004) discusses, the introduction of an STT has the potential to curb excessive speculation in the Indian stock market. Moreover, it was expected that this new taxation policy would also help the government to mobilize more revenue from the financial investors.

However, the modified STT regime is considerably different from the one proposed in the budget speech. The new STT retains the 0.15 percent transaction tax only on long term investors who take delivery of their shares. Contrary to the original STT, in the new proposal the buyer and seller will be splitting up the tax burden equally between them. For day traders, arbitrageurs and jobbers the tax rate has been brought down by ten times from 0.15 percent to 0.015 per cent. Transaction tax on derivatives has been brought down to 0.01 per cent instead of the original proposal of 0.15 per cent. Buying and selling of debt securities and bonds including Government bonds have been totally exempt from STT. It is interesting to note that though the STT rates have been drastically revised downwards, the finance minister has not reverted the capital gains tax rates, which were lowered in the original proposal.

One of the main reasons for imposing the STT was the fact that most stock market players manage to avoid or evade the capital gains tax. It was expected that in a computerized system of stock market trading, the transaction tax will act as a tamper proof and low-cost method of collecting revenue from a section of the population who pays relatively little tax. However, the new STT brings the tax rates down by a factor on ten for all short term and non-delivery based trading in the market. This defies economic logic as 55 to 60 percent of total stock market transactions are short-term non-delivery based trade and because of this reduction, the government is likely to face a further resource crunch in the already constrained fiscal situation. It is estimated that because of the rollback of STT and the concurrent reduction in capital gains tax rates, the total revenue earned by the government from this instrument will come down from Rs 7,000 crores to Rs. 1,000 crores only, causing a massive shortfall of Rs 6,000 crores^[2] . It is not clear from where the finance minister is going to cover this revenue loss. To put this shortfall in perspective, the total allocation for rural employment programmes in the Budget for 2004-05 is only Rs. 4,590 crores. From a principle of equity, it is difficult to justify dolling out such fiscal largesse to a very small group of relatively well-off people who are involved in short term speculation^[3]. It must be reiterated once again that long term investors have not been given any new tax benefits in the modified STT scheme.

This rollback of STT is going to take away most of the other perceived benefits of the original STT system as well. The new STT is essentially going to benefit arbitrageurs and traders who indulge in very short term speculative trading. This is likely to increase the level of speculation in Indian stock markets. Though it can be argued that speculation, which is based on fundamentals, is essential for functioning of the financial markets, it is well known that in most stock markets, even in developed markets, fundamentals play relatively little role in the determination of stock prices^[4]. This phenomenon is more widespread in developing country markets where speculation and market manipulations are more common. In India, repeated scams since 1992 have shown how stock market prices are manipulated in this country. It will be extremely difficult for anybody to argue that the wild mood swings of the Sensex (Fig) can be explained by changes in the underlying economic or financial fundamentals. In fact, to a large extent, trading in the BSE is dominated by day traders, who are essentially noise traders. Noise traders are very short term speculators who trade on thin margins and make their profits by trading huge volume of securities. These transactions are purely speculative, very short-term in nature and are not based on economic or financial fundamentals of the companies. It is unfortunate that the new STT is going to benefit and promote precisely this type of trading activity in the stock market. There is a strong possibility that long-term investors will be reluctant to enter the stock market if noise traders can cause price of shares to decouple from their fair value for long periods of time^[5]. Increased speculative activity is also likely to increase the volatility of share prices in India.

Chart 1 >> Click to Enlarge

Apart from day traders, another category of investors who are likely to benefit from the new tax structure is the foreign institutional investors (FIIs). In the previous tax regime, FIIs were required to pay 30 percent tax on short term capital gains and 10 per cent tax on long term capital gains. However, the Double Taxation Avoidance Agreement (DTAA) between India and Mauritius allows FIIs, who are registered in Mauritius, to get away with much lower capital gains tax rates. According to the DTAA, individuals and companies that are residents of Mauritius will pay their tax only in Mauritius and not in India. Given the fact that Mauritius has no capital gains tax, FIIs operating through that country effectively do not pay any capital gains tax. However, these FIIs are required to file their returns in India. The new tax system will significantly reduce the tax burden of the non-Mauritius based FIIs and will also reduce the paperwork involved in filing capital gains tax returns. The new tax structure also makes the Mauritius route almost redundant and saves the FIIs from the inconvenience of adding a layer to their operational set up in that country. As additional sops to FIIs, the investment ceiling for FIIs in debt funds has been raised in the current budget to US$1.75 billion from the existing ceiling of US$1 billion. The government also proposes to make the procedures for registration and operations of FIIs simpler and quicker to attract greater inflow.

However, it is not clear why in every single budget since 1992, FIIs are given special favours. FIIs are already a dominant force in Indian stock markets. Given the huge amount of foreign exchange reserves available to India, the incremental benefit from increased inflow of portfolio capital is minimal. In fact, recent empirical evidence from a number of cross-country studies has pointed out that among various forms of foreign investments, foreign portfolio investment is the least effective in promoting domestic investment and growth. These studies reveal that the contribution of portfolio investment to domestic capital formation is lowest among different types of capital inflow. Table 1 summarizes the main findings of some of these studies.

 

Table >> Click to Enlarge

Also as Chandrasekhar (2004) highlights, since 1992, India has received an excess inflow of foreign portfolio investment which is making macroeconomic management of the economy extremely difficult. Given these problems with portfolio investment, it makes little economic sense to keep extending fiscal sops to portfolio investors.

To sum up the discussion, it can be said that the original securities transaction tax (STT) was an innovative idea to tax financial investors. It would have curbed excessive speculative trading in Indian stock markets and could have generated significant revenues for the government. However, the finance minister's decision to significantly alter the STT rates will now not only allow a very high proportion of stock market players to get away with paying very little tax but it will also promote very short term and disruptive speculative trading. In a year when the total allocation for the National Common Minimum Programme has been only Rs 10,000 crores, it is difficult to understand why the finance minister relented to the pressure from a few stock market players and effectively diluted a major source of revenue earning for the government.


[1] Short term capital gains from securities is defined as profits made due to such sales within the year
[2] The Economic Times, 22 July 2004
[3] ''The brokers who were vocal last week in their protests against the proposed 0.15 per cent levy on daily turnover in securities transactions have expectedly been identified as a group of 100-odd arbitrageurs.'' -‘Sensexy, it's not – daily wagers on the rampage', Nandu R Kulkarni in Mumbai, The Statesman, July 12 2004. According to Sucheta Dalal: ''There are 1,300 active brokers on the NSE and BSE's equity segment and 75 in the debt market.'' In ‘Real impact of transaction tax on people's life' Indian Express, July 26th 2004.
[4] For example, Shiller (1981, 1984) shows that changes in fundamentals could account for only one-fifth of the high volatility in stock prices. This observation is also supported by Campbell and Shiller (1987), Fama and French (1988a, b), and Poterba and Summers (1988).
[5]See Noise Trader Risk in Financial Markets' by De Long et.al
Bosworth and Collins (1999), World Bank (1999) and World Bank (2001)

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