Budget 2004-05: The (Modified) Turnover Tax
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.
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.
Author |
Time
Period and Country Coverage |
Conclusion
|
Bosworth
and Collins (1999) |
1978-95 (for 58 developing countries) |
Every
dollar increase in capital flows was associated with an increase
in domestic investment of about 50cents (Above 80 cents for FDI,
close to 10 cents for portfolio flows and about 50 cents for loans). |
World
Bank (2001): Global Development Finance, 2001, chap3. |
1972-98 (for 118 countries) This study uses the same methodology as Bosworth and Collins (1999) but uses a larger sample and longer time period. |
Every
dollar increase in capital flows was associated with about 80
cents increase in investment (close to 90 cents for long-term
capital, 25 cents for short-term capital, above 80 cents for FDI,
more than one dollar for bank lending and about 50 cents for portfolio
flows). |
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)
Reference:
Bosworth, Barry, and Susan M. Collins. (1999): ''Capital Flows to Developing
Economies: Implications for Saving and Investment.'' Brookings Papers
on Economic Activity 1: 143–69.
Campbell, J. and R. Shiller. (1987): ''Cointegration and Tests of Present
Value Models.'' Journal of Political Economy 95: 1062–87.
Fama,
E.F. & French, K.R. (1988a), ''Dividend Yields and Expected Stock
Returns'', Journal of Financial Economics, Vol. 22, pp. 3-25.
Fama, E.F. & French, K.R. (1988b), ''Permanent and temporary components
of stock prices'', Journal of Political Economy, Vol. 96, No. 2, pp.
246-270.
Poterba, J.M. and Summers, L.H. (1988), ''Mean reversion in stock prices:
evidence and implications'', Journal of Financial Economics, Vol. 22,
No. 1, pp. 27-59.
Shiller, R.J (1984): ''Stock Prices and Social Dynamics.'' Brookings
Papers on Economic Activity 2: 457–92.
Shiller, R.J. (1981): ''Do Stock Prices Move Too Much to be Justified
by Subsequent Changes in Dividends?'' American Economic Review 71: 421–36.
World Bank (1999): Global Economic Prospects and the Developing Countries:
Beyond Financial Crisis, Washington. D.C.
World Bank (2001): Global Development Finance 2001, Washington. D.C.