Taxing the Losers to Benefit the Gainers

Taxing transactions that result in losses is not something that any Government would like to do. And, increasing the tax rates on such transactions is something that no Government would want to be associated with. But if the Parthasarathi Shome Committee’s recommendations are anything to go by, the Government should increase the securities transaction tax, irrespective of whether an investor is making money or losing it.alt 

This is even as the former IMF economist has recommended that the Government do away with any tax on short-term capital gains, an area where every investor is actually making a profit, with the amount too being significantly less than what the Government earns through the STT. His logic: it will boost investments by both global and domestic fund houses. But in the process, Shome is asking retail investors and traders to bear increased costs.

Today, short-term capital gains on listed securities are taxed at a rate of 10-30 per cent (depending on the class of investors) in case of ‘gain’ or profits on transaction squared off within a year, STT is a tax levied on every transaction, irrespective of it being profitable or one that results in a loss. Also, STT is applicable to the gross value of a transaction and not on the resulting profit or loss. 

The Shome Committee’s primary argument for doing away with the capital gains tax was that the Indian tax authorities would no longer have to worry as to how foreign investors and non-resident investors characterised their profits – most avoided paying tax by not being registered in the country. The aim was to make it more attractive for foreign investors to operate directly out of India, rather than route investments to countries that do not levy any tax on capital gains. 

However, as leading market players observe, this is one tax that will certainly drive down volumes in the cash market, which today account for less than 15 per cent of the volume on the stock exchanges. This is because any increase in transaction cost is certain to lead to some decline in volumes. On its part, the Securities and Exchange Board of India too has called for tax to be kept at levels which would incentivise people to make investments for the long-term. Shortly after the Shome Committee submitted its report, SEBI Chairman UK Sinha was quoted as saying that the STT rate was rather high now and “it should be used in a manner that people (investors) are incentivised to invest for the long term rather than for the short term (speculation).” As Benjamin Franklin famously said, “in this world nothing can be said to be certain, except death and taxes”. In 1789, Franklin was talking in the context of the freshly minted US constitution, which everyone expected to ‘promise permanency’, but the quote has taken a life of its own as a statement about the inevitability of taxes. Right from its introduction, STT collections have been robust and growing, with two exceptions – in 2008 and 2011-12 when the collections declined. For the current year, the STT collection has been pegged at 70 billion, an amount that is not insignificant in the overall revenue budget. And it is a collection of just ` 30 billion—an amount the Shome Committee notes as being the small-term capital gains mop-up—that the STT should be increased to make up for. 

When financial markets are functioning well, capital is put to its most productive use. The opportunity set available to firms and households expands, resulting in higher growth rates and more inclusion. Thus, financial markets work as enablers with a multiplier effect on the economy. By taxing financial transactions of any kind, we reduce the efficiency of price discovery in these markets, which in turn delays the processes of adjustments to changes in demand and supply. These taxes are especially problematic when they prevent arbitrage between different markets. 

An important natural experiment in the impact of STT has been the relationship between STT and the options market. Today, NIFTY options are one of the most active contracts globally. However, before 2006, there was very little liquidity in this contract, as STT was being charged on strike price plus premium, making the STT the largest element in the contract. The reduction of STT on options allowed this market to develop, and consequently allowed the creation of structured product offerings that used these options for hedging. Like all other taxes, taxes on financial transactions tend to distort economic decision making.

The application of STT in India has also created distortions because it is not uniformly applicable across all asset classes. Traders’ decision to provide liquidity in a particular asset class is based on the overall costs of trading that asset. We need to find ways to improve governance and manage systemic risks, but at the same time, we need to keep transaction costs within manageable levels. Only then will financial institutions be able to make full use of markets to provide the products and services that are required by a fast maturing economy. Removal of STT alone may not have a significant long-term effect, though it is likely to improve optimism and provide a boost to markets. Removal of STT is a low hanging fruit, and must remain high on the policy agenda.

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