A tax turnaround

Bowing to pressure from players in the capital markets, the Finance Minister dilutes the provisions of the securities transaction tax which had the potential to curb speculative excesses in the stock markets.

TWO weeks after presenting the Union Budget, Finance Minister P. Chidambaram, was forced to roll back a key tax proposal. Addressing the Lok Sabha on July 21, he announced a substantial dilution of the provisions of the Securities Transaction Tax (STT), which had been welcomed widely as a progressive measure. Apart from mobilising resources, the tax had the potential to curb the rampant speculation in the financial markets in general and the stock markets in particular. The rollback is an obvious capitulation to the powerful vested interests that lobbied hard against the new tax proposal. The dilution of the STT dims the possibility of the government using it as a tool to reform the stock market, which has been a victim of speculative excesses in the past decade.

Significantly, the revenue mobilisation figures presented by Chidambaram are likely to go seriously off target. The government, which had hoped to gather Rs.7,000 crores from the imposition of the STT, is now likely to raise only Rs.1,000 crores. This is apart from the losses that government would incur because of the concessions made in the capital gains tax.

Chidambaram proposed that every transaction in securities in the recognised stock exchanges would attract a "turnover tax" of 0.15 per cent. Transactions in stock and index options and futures would also be subject to the tax. However, transactions carried out on the Negotiated Dealing System (NDS), an online system for trading in government securities and bonds operated by the Reserve Bank of India, were to be kept out of the purview of this tax. Only buyers of securities were to pay the proposed tax. The stock exchanges were made responsible for the collection of the tax, from the brokers.

Market players launched an offensive immediately after the presentation of the Budget. Despite the fact that the proposals in the Budget come into effect only after the Finance Bill passed by Parliament obtains presidential assent and is notified by the government, a process that is likely to take three months from the date of presentation of the Budget, stock prices tumbled. Brokers succeeded in halting trading in the debt markets the day after the Budget presentation itself. According to senior Finance Ministry officials a "cartel" of brokers managed to hold the entire market to ransom.

THE imposition of the STT cannot be separated from the other changes that the Finance Minister has announced. While the short-term capital gains tax (held for less than one year in the case of shares and other securities) was reduced from 33 per cent to 10 per cent, the long-term capital gains tax was abolished. Given the fact that these concessions would lead to lower revenues, the STT was imposed in the hope that it would help the government recover at least a part of the revenues lost as a result of lower capital gains tax rates.

The STT is regarded as an efficient, progressive and transparent method of taxing securities transactions because it is difficult to evade and easy to collect and is loaded against speculators. Since the STT did not differentiate between short-term and long-term transactions, the tax is biased inherently against short-term investors like day-traders, arbitrageurs and others who make swift short-term transactions. High volumes, rather than large margins, are what motivate these swift-dealers.

Moreover, the STT is also a device that can slow down the phenomenon of speculators and traders making swift profits by merely trading without actually possessing or delivering the securities they trade in. The STT, by imposing tax on such speculative deals, would impose a cost on such transactions.

Although Chidambaram defended his proposal, he showed an immediate willingness to bargain on it. He told industry chambers on July 12 that although the STT is "efficient, neat, non-regressive and eliminates tax avoidance", he was prepared to "revisit the numbers" and "fine-tune" the proposal. He argued that the new proposal ought to be seen in the context of the concessions offered on capital gains. He appeared to pressure those who called for the dismantling of the new proposal when he said that a review of the STT may have to be accompanied by higher tax rates on capital gains, both long- and short-term. In short, Chidambaram appeared to suggest that a trade-off between capital gains tax rates and the STT rates would be on the cards if and when he would "revisit" the STT rates.

Critics were aghast that the Finance Minister was even considering such a scheme. The logic of taxing capital gains is that gainers in speculative transactions should pay a portion of the profit to the exchequer. It is for this reason that gains made on long-term holdings of capital assets are charged lower rates of taxation when compared to short-term capital gains. While it is true that market players enjoy a plethora of ways to fudge their capital gains, a trade-off between this tax and the STT would be illogical. Although the rate of the proposed STT was low, at 0.15 per cent, its applicability across-the-board on all transactions in the stock exchanges meant that it would plug the loopholes.

While this would boost the government's coffers, the more important aspect of the proposal lay in the fact that it would act as a trip on speculative behaviour in the bourses. By conflating the issues relating to the two different kinds of taxes, Chidambaram indicated to the players that the Finance Ministry was willing not only to bargain with them but also soften the blow on speculative forces operating in the bourses.

WHEN Chidambaram "revisited" the numbers on July 21, he changed the original proposal so drastically that it was barely recognisable. He offered three different rates to different sections of the market. Surprisingly, the highest rate of STT, of 0.15 per cent, would be borne by those who dealt in delivery-based trades in equities. The STT rate on day-traders (the super speculators who buy and sell securities within the day's trading) and other arbitrageurs, who were the most vocal critics of the new tax, were virtually spared the tax. Chidambaram slashed the STT rate applicable on such speculative transactions to one-tenth of the original proposal - 0.015 per cent of the value of their transactions. In addition, he announced that they would be allowed to set off the STT payable against the taxes that they paid on profits.

A significant concession was also made to derivative traders. The STT rate applicable on future and options trades was pegged even lower - at 0.01 per cent instead of the original 0.15 per cent. These traders were also allowed to claim credit for the STT paid against tax on business profits. The "fine-tuning" means that buyers and sellers will now have to split the burden of the STT applicable on delivery-based transactions. Moreover, intermediaries who declare business profits on delivery-based transactions can now claim credit for STT against the tax paid by them on business profits. The revised STT envisages that the trade in bonds and debt instruments would be exempted from the tax. The exemption of debt instruments from the purview of the STT has been generally welcomed because of their "underdeveloped" nature.

L.C. Gupta, director, Society for Capital Market Research and Development (SCMRD), observed that the Indian stock markets functioned like "betting bazaars". According to him, day-trading has come to enjoy "overwhelming" influence on the markets, making it unsuitable for long-term investors.

Studies conducted by the SCMRD have shown that day-trading accounts for 80-90 per cent of the trading volume in the spot as well as futures segments in Indian bourses. This means that only a fraction of the trading results in actual consummation of the transaction, that is, resulting in the delivery of securities. This is the state of the market after the adoption of the rolling settlement system, which replaced the notorious badla system.

"What are markets for?" asks L.C. Gupta. "Markets are supposed to serve the interest of the real economy and in order to do that they need to reflect the happenings in the real economy. If they do not perform this function, they cause harm. Day-traders are not concerned with the real economy." He points out that these speculative excesses drive out "real" investors because they look for "real economic issues". L.C. Gupta also dismisses the brokers' argument that the STT would reduce trading and, therefore, the liquidity in the stock markets. He points out that intra-day volatility in share prices, particularly blue chips, is very high in India, often as high as 5-6 per cent. He pointed out that excessive volatility is detrimental to the interests of genuine investors even if trading volumes are high.

THE revised STT defies the very logic of such a tax. The higher STT rates on delivery-based transactions, which are less speculative than non-delivery based deals, robs the STT of its use as an instrument to curb excessive speculation. Instead of taxing day-traders and other purely short-term speculators, it penalises those who participate in delivery-based transactions.

After all, non-delivery based deals involve players betting on stocks without actually possessing them. L.C. Gupta said that the fact that the government would earn less than what it projected earlier from the measure was only the smaller problem. "More important, the government has failed to regard the STT as part of a measure to reform the capital markets," he said.

L.C. Gupta said: "Chidambaram has turned the logic of the STT upside down. Now the stock markets will muddle along, under the sway of speculative operators."