Turn over this tax

Indian Express, 19 July 2004

It must apply only to FIIs who evade tax using the Mauritius route

Financial markets have been on a march to North Block against the proposed tax of 0.15 per cent on stock market transactions. Finance Minister P. Chidambaram has said that a 0.15 per cent turnover tax would be roughly ‘revenue neutral’. It is accompanied by reducing the short-term capital gains tax and eliminating the long-term capital gains tax for securities traded on the stock market.

But while the total tax collections might be roughly the same, the turnover tax hurts. Suppose there are two different transactions worth Rs 10,000, one of which makes a profit of Rs 500 and another which makes a loss of Rs 500. Both pay a transaction tax of Rs 15, but the capital gains tax treats them differently.

The proposed 0.15 per cent is expected to reduce market liquidity. But if the rate is slashed uniformly, it raises a problem: where would the revenue come from? Among the options being considered today is the move to have differential rates for different kinds of transactions, different market players, different products and exemptions for some. During the last few days there have been demands from the debt markets, brokers, UTI, LIC and mutual funds for differential rates and exemptions on the turnover tax and also on the long term capital gains tax, where it still applies.

This will create a complex web of taxes for financial markets. First, it is dangerous to introduce a tax which is based on unsound principles, even if it can be easily collected. The differential rates will create fresh market distortions. The tax would be making some markets and trading strategies more profitable than others. In addition, differential rates will become a source of lobbying and arbitrariness.

India’s experience with custom duties has been similar. Once customs duties were introduced, they became an easy source of tax revenue. The incompetence of tax administration, in the areas of income tax and the value added tax, led to poor tax revenues. Customs duties were an easy drug for public finance: they were raised year after year in order to augment tax revenues. By 1987-88, over 36 per cent of India’s tax collections came from customs.

Second, differential duties created incentives to produce certain goods and not others. The structure of tariffs shaped production patterns and techniques in Indian manufacturing.

Third, custom rates became a source of intense lobbying. Even though this was well recognised as a source of inefficiency for the economy, it became difficult to get rid of differential rates. Undoing the damage done by the plethora of rates and end-use specifications has taken over a decade.

Looking back, we now see that the introduction and reliance on customs duties was a completely incorrect response to the inefficiency of tax collection. The correct response — at that time — should have been to modernise the tax administration, and build a sound framework for value added and income taxes. India has paid a heavy price for resorting to customs duties.

Similarly, today the correct response to the issues in financial market taxation is not the custom duty route. The turnover tax is not based on the sound principles of public finance that call for taxing only income or value added. Differential rates will influence market behaviour and structure, which is not desirable. Differential rates will lead to lobbying till they get eliminated. And, that will be another long battle.

What are the other options before Finance Minister Chidambaram? First, let us remember that a ten-year effort on the financial market reform has worked on creating modern new market structures where trading would take place with the lowest possible transactions costs. East Asia markets have not shot up to the world’s third largest exchanges, NSE has! It is because we have reduced transaction costs that small retail investors participate in the markets in a big way. We should rejoice that small trades account for 92 per cent of trading volume in India.

Second, we should be clear that the transaction tax will reduce liquidity in the market. The concept of the transaction tax comes from the Tobin tax. The goal there was to introduce friction — or ‘sand in the wheels’ of the financial markets — to reduce trading activity and to prevent speculation. The transaction tax was designed to achieve this objective. Today it is understood that financial markets need speculation for liquidity and price discovery. It is unreasonable to propose a transaction tax and expect it not to hurt liquidity. It is similar to building speed-breakers and expecting traffic not to slow down. It also contradicts the reforms programme in finance: on the one hand, the government is trying to build eight-lane expressways and, on the other hand, the tax system would be throwing up speed-breakers to undo this good work.

The transaction tax cannot be justified on the basis of good economics. On the grounds of tax administration, Chidambaram could stick to the proposal of replacing the long term capital gains tax by the turnover tax, but — only for FIIs — who are able to evade it through the Mauritius route. For domestic investors, who account for 98 per cent of the trading volume, and who will be hit the most, the best option would be to continue with the capital gains tax — with improved administration. All trading on the stock market now takes place through electronic exchanges, where there is a 100 per cent audit trail. Even though as much as 3 million transactions take place every day on the exchanges, tax authorities can now get a complete record of all transactions.

The tax authorities have recently created the Tax Information Network (TIN). The system will help bring all information about each tax payer into a single account. Chidambaram should announce that the TIN database will now be integrated with the database of all transactions of the exchanges, so as to produce complete information about capital gains. This would also address the record-keeping and compliance costs faced by investors, who would be able to get a single statement from TIN about all their transactions of the year.

Ila Patnaik