The impact of transaction tax on securities

Exempt debt, F&O segments

ANAND RATHI
Chairman,
Anand Rathi Securities

The objective behind the Budget proposal of transaction tax was primarily to attract foreign institutional investors (FIIs) who will find it easier to work with. However, the implication of the proposed tax are much wider. Let's take a look at them first:

Capital gains tax: The assessees after the introduction of transaction tax would not be required to pay any tax on long-term capital gains tax and the tax on short-term capital gains will be reduced from 30 per cent to 10 per cent. Thus there is a trade-off for these categories of assessees.

Business income: Investors, whose income from securities in transactions are assessed under the head 'business income' would continue to pay income tax at the full rate applicable to them and also pay the transaction tax, resulting in double taxation.

Speculative income: In this case again the assessees will have to continue to pay tax as before but will be liable to pay additional transaction tax.

Mutual funds: While mutual funds would be liable to pay transaction tax on the transactions done by them, the short-term or long-term capital gains made by the assessees on sale of mutual funds would be taxed at the earlier rates "" 10 per cent on long term capital gains and 30 per cent on short term capital gains and no relief (as per the present proposal) on capital gains tax would be available to the assesses dealing and investing in mutual funds.

Thus, proposed transaction tax would be payable by all categories of tax payers but the advantage of reduction in tax would be available only to those paying taxes on capital gains.

Therefore, it does not appear reasonable that those who are not offered any tax relief are also liable to pay the transaction tax. Let us examine the implications of the transaction tax on different categories of products:

Debt: Substantial debt transactions are recorded on wholesale debt market segment of the National Stock Exchange and would be considered as transacted on the stock exchange.

The spread on the debt transactions itself is one or two basis points and it would, therefore, be unviable and undesirable for any transaction cost to be levied on the debt segment.

Equity: The equity markets could be divided into futures and options (F&O) markets and cash markets. In them, investors could be categorised as jobbers/market makers, arbitrageurs, day traders (who do not take or give deliveries) on one hand and investors (who take and give deliveries) on the other.

F&O: The present spreads/cost of transactions vary between 2 basis points to 5 basis points. A levy of 15 basis points will bring down liquidity and perhaps result in closure of this segment.

Day traders/jobbers/arbitrageurs in cash market: All these categories of investors work at a transaction cost of 3 to 5 basis points. Many brokers act as jobbers, day traders and arbitrageurs and, therefore, there is hardly any transaction cost to them. Hence a transaction cost of 15 paise can only kill the volumes in the market.

Investors: Their present cost of transaction typically ranges from 10-30 basis points. Out of this category those whose income from security transactions are assessed under the head capital gains tax may be in a position to bear the transaction cost (albeit not at the proposed rate of 15 basis points) as they have a trade-off in reducing the capital gain tax.

However, for other investors, whose income is being assessed under business income, it will result in double taxation.

It makes sense that the tax in lieu of capital gain tax is levied on the sales as capital gains tax is also levied when the sale is made.

In fact, it is sensible and rationale to levy on sales as otherwise those who are holding stock for long term may now sell these stocks and will not pay either transaction tax or capital gain tax.

Given the complexities, the finance minister would do well to look at some alternatives. For instance, levy the transaction tax of 0.05 per cent to 0.1 per cent only on FIIs and exempt them from both short term and long term capital gains tax.

And if the transaction tax is to be levied across the board, then the debt and F&O markets should be exempted and the tax should be restricted to a nominal 1-2 basis points.

Killing market making

VIPUL AMBANI
Chairman & MD,
Tower Capital & Securities

The Budget has introduced the transaction tax for the ostensible reason of raising revenues from capital market participants, given their dominant role in the Indian economy.

However, in the context of cost, benefit and liquidity, it looks to be a measure that could invalidate the market making function that is so desirable to lend depth.

As far as the debt market is concerned, the tax itself would not serve any purpose for participants. This is on account of the fact that over 95 per cent of the debt market is dominated by institutional clients who treat trading income as business income and not capital gain.

Thus, for all practical purposes, the transaction tax becomes an additional levy and not a substitute. Moreover, these institutional clients "" banks, primary dealers, mutual funds and insurance companies "" are well regulated market participants.

The second and probably larger issue of transaction tax is its implied impact on the cost of borrowing for government and corporates.

With our proposed growth rate of over 7 per cent and the combined fiscal deficit of the Centre and the states close to 10 per cent, the severity of the proposed tax would be high on both private and public sector.

The third impact would be on the market structure "" volume (liquidity) and price discovery. This would raise a question on the expected revenue (via the proposed transaction tax).

With the proposed transaction tax, volumes would be negatively hit as higher transaction would push market participants into a passive mode. Even empirical studies have proved that the elasticity of trading volume with respect to transaction costs is between -0.25 and -1.35.

So as the tax rate increases, the trading volume would decrease.

Even globally, transaction tax has been a well-debated issue and many countries (developed as well as emerging economies) have looked at the option of introducing this tax to boost revenue or control market volatility.

But in recent years, they have been reduced or eliminated with the perception that the taxes were contrary to the priority of allowing financial markets to operate in an untrammeled fashion.

There have been instances of a few emerging and advanced economies of the world having a transaction tax as part of the revenue raising programme. However, it needs to be noted that the developed economies like Switzerland run surplus budgets and do not need to support large borrowing program.

On the other hand, developing economies like Pakistan and Argentina have deficit budgets and have large borrowing requirement which also tend to lead to inflationary conditions, given the low maturity level of their capital markets.

India is in a league of its own where the government borrowing programme continues to be on ascendancy and replicating any other international model may prove to be a self-defeating exercise.