Taxing transactions

The pre-Budget buzz reflects the expectation that the finance minister will abolish the current capital gains tax and replace it with a turnover tax on capital market transactions.

The main motivation behind this move is that it will bring about a level playing field between domestic and foreign investors. The former now pay taxes at the same rate as on any other income if the gains are realised in less than a year.

If the gains are realised after a year, they pay 10 per cent on the gains from listed stock (20 per cent for other assets). The latter, predominantly foreign institutional investors (FIIs), who have brought their funds into the country through Mauritius, which has a well-known tax treaty with India, pay a tax of 10 per cent on gains realised in under a year and nothing for gains realised beyond that.

There has been much heartburn over the fact that the FIIs, who have been very active players in the market, are able to get away with not paying their fair share of taxes.

However legitimate the sentiments against FII tax avoidance may be, there are many reasons why a turnover tax might not be the right way to go.

In terms of revenue collections, this newspaper's own estimates suggest that, with a tax of 0.01 per cent levied on current volumes of transactions in the equity markets, collections would be a rather small Rs 1,250 crore a year.

This, of course, has to be set off against the realisations on capital gains taxes, so the net revenue gain may well be insignificant.

As far as the tax itself goes, the great danger lies in the temptations that all future governments will have to expand its scope. A finance minister hard-pressed for revenues one year might just decide that all cheque transactions are worthy of a tax. Before one knows it, airlines and hotels may be subject to one, over and above what they already pay.

When the government is supposed to be making serious efforts to bring as many transactions as possible over ground, so that they can be charged the taxes they are supposed to now, an additional tax will simply push even more transactions underground. This is hardly consistent with the stated long-term objective of a sustainable increase in the tax base.

As far as the capital markets are concerned, the essential merit of a capital gains tax is that is paid only when a gain is realised. Turnover taxes will apply regardless of whether a transaction turns out to be profitable or not.

There will be enormous resistance to paying it, as a consequence, and many trades will be deterred. FIIs could well decide that the return on their investments in this country, after having paid the tax, do not warrant the magnitude of exposure that they have.

All said and done, India's capital markets may have come a long way but they are still far from the level of maturity which would persuade investors to accommodate such a tax. A turnover tax is undoubtedly a tempting solution to a problem, but it is just as clearly the wrong one at this point in time.