India: Turnover Tax, Policy Roll Back and Investor Community

2004

Professor D Tripati Rao

The repeated history of financial crashes has demonstrated that shortcomings in macroeconomic policy can result in a failure to ensure orderly financial markets, sometimes with cataclysmic economic and social consequences. The Southern Cone (Latin American) capital flight crisis in the late 1970s, the 1994-95 Mexican currency crisis or 'Tequila Effect', and the 1997-98 Asian financial crisis all have a common story to tell, which is that left to themselves financial markets do not behave in an orderly manner. They are prone to bouts of convulsions after even a slight change in 'information processing', macroeconomic variables. But then introducing measures to supervise and regulate financial markets has not met with much success. There is a stiff resistance from financial participants with a conflict of interests between macroeconomic objectives and the immediate interests of financial market participants seeking to maximize their profits. A furore was raised recently in Asia's oldest stock exchange, the Bombay Stock Exchange (BSE) along with its offspring National Stock Exchange of India (NSE), as soon as it became known that the Indian 2004-05 Budget had mooted a proposal to wind back the 'Turnover', or otherwise known as the 'Transaction', Tax.

This raises the question: how do we judge policy measures-from a pure investor perspective or from a long-term financial stability point of view? Did the government introduce the turnover tax simply to ensue an orderly financial market in the longer term or was it a government gripped by 'fiscal conservatism' with a 'balancing act' in mind-seeking to make revenue while attempting to keep everybody in good humour? If the objective is the former, can it be likened to the Tobin Tax which is intended to 'throw sand in the wheels of the foreign exchange market' to reduce destabilizing speculation and gain 'traction' so that the stock market will move in tandem with 'macroeconomic fundamentals'? Such questions have larger implications with a wider resonance for emerging economies.

In India at the present time, a conservative investor is merely looking for a minimal return that provides insurance cover against a rising inflation rate of 6.5-7.0 per cent. For the small investor, the ability to earn money has come to an impasse. A foray into the stock market could be an option. Research has shown that investment made on the basis of sound fundamentals can give an annual average return of 10-14 per cent. Why then has a turnover tax as insignificant as 0.15 per cent generated such a furore, bringing stock market operations to a virtual halt? Why is a 15 paise tax on an investment of Rs.100 so hard to digest for the investment community?

The turnover tax is a tax put on every transaction above the turnover amount. It is easy to collect as the tax gets deducted at the broker's end. There will be less speculative trading for there is a disincentive to trade frequently. Why are the brokers so concerned? Basically most of the trade in the stock market is speculative and not delivery based. The broker will have to bear a transaction tax for every transaction. This will result in the drying up of volume, driving investors towards a completely illegal market referred as the 'dabba' market-a largely word-of-mouth stock trading system, operated by erstwhile brokers who do not register the transactions with the official stock exchange, thus bypassing the regulatory body and leading to tax evasion. Since all trade is done through a broker, the honest investor has to fall back on the traditional bank and in the process lose money with each increase in inflation. Indeed, there may be loss of revenue for the government and this may create more problems for the regulator in terms of price distortion and market manipulation. For a 'volume driven' market with the profit margins being around a slender six per cent, in the current scenario of high inflation, the transaction tax would be a nail in the coffin for the investment community, and particularly the brokers!

Therefore, after concerted effort by the investment community, the regulator (the Securities and Exchange Board of India (SEBI)) and the broker community, the Finance Minister finally drew a truce by amending the structure of the transaction tax. The new transaction tax will be on delivery-based transactions, and the 0.15 per cent tax will be shared between the buyer and the seller. For day-traders and arbitrageurs (paying income rather than capital gains tax), the turnover tax has been cut sharply to 0.015 per cent from 0.15 per cent. In the futures and options segment, the tax has been cut sharply to 0.01 per cent from 0.15 per cent. Finally, for the bond and debt market, the transaction tax has been removed. The market responded very well to the new tax regime as was evident from the bull-run that followed the Finance Minister's statement. Now the investment community is looking to the skies to ascertain the future direction of the stock market. An investor will be left to ponder whether money making is really as easy as it seems in the stock market or whether something called 'common sense' does exist when the genuine 'hard working-honest-sincere' Indian goes to the bank to lose his money. It may be that the banks ought be compared with the results of smoking. That is, if you have to die, then you die slowly, whilst enjoying its pleasurable effects (the 3.5 per cent return as compared to the 6.5 per cent inflation); rather than die quickly, but with more dramatic effect, by playing on the stock market.

WATCHPOINT: What needs to be seen is the amount of revenue that will be generated from this meagre percentage of turnover tax and whether it can be effectively utilised in terms of improvements to the financial infrastructure. Otherwise, it will be viewed as a fiscally conservative government resorting to another populist roll back measure, thereby confusing the investor community and ending up with a loss-loss situation for both the government and investor.

 

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