Turnover tax troubles

The turnover tax has been universally criticised so much that one can be sure it will undergo big changes before it becomes law. However, it is important to ensure that the quality of thought going into making these changes is much better than what went into the Budget proposals. The finance ministry needs to lend a willing ear to serious objections, but it must also learn to differentiate between self-serving protests and those that are critical for market survival.

As things stand now, the Budget proposals make no distinction between securities transactions on the bond, F&O and share markets. Shrill protests have come from all segments.

Of the three, the worries of the bond markets are legitimate because trading in GOI securities is at the very core of treasury management. The tax on bonds traded in the wholesale debt market needs to be eliminated altogether.

As for the F&O segment, rates need to be dramatically lower than the 0.15 per cent currently proposed if derivatives are to hold any attraction for hedgers.

This leaves us with share transactions. There is much to be said for the replacement of long-term capital gains tax with turnover tax. Investors with a long-term interest in the markets, including the FIIs who were most interested in this proposal, will definitely welcome this change as it does away with the need to balance capital gains against losses, or maintain a lot of paperwork.

The tax will also be easier to collect, since collections will be centralised through the stock exchanges. In fact, the introduction of turnover tax can, if explained to retail investors the right way, actually spur more direct retail interest in equity. Another objection to turnover tax is that the tax will be levied on buyers, and not sellers.

Actually, it may not make much difference either way. Every transaction has a buyer and seller "" who pays the tax hardly matters much. The most important argument used by opponents of the turnover tax is that it will deter day-traders, who provide much-needed liquidity to the markets.

It is certainly true that day-traders increase volumes by weaving in and out of shares, but it is doubtful whether real liquidity should depend so much on them. The real test of a market's depth is not the amount of daily churn created by day-traders, but the number of serious investors it is able to attract.

The loss of volumes through a decline in day-trading will, over the medium term, be made up by the entry of real buy-and-hold investors, thanks to changes in the capital gains tax regime. It is worth recalling that the liquidity bogey was raised even earlier, when badla trading was about to be banned.

The heavens did not fall, and the markets have only benefited from the reforms. The turnover tax, if modified and enforced correctly, has the potential to widen the circle of long-term investors.

Real liquidity flows from growing the population of serious investors and not merely pandering to intra-day speculators. This is not to say that they don't have a role to play, but they can learn to live with the turnover tax.