The Hindu : Business : A step in right direction

Online edition of India's National Newspaper
Monday, Jul 19, 2004

Business

Business

A step in right direction

The Finance Minister is expected to announce changes in the proposed turnover tax on capital market transactions today while replying to the budget debate. Two views on the rationale of the new tax are presented here.

IN 1997, the stock market reacted positively when P. Chidambaram in his previous tenure as Finance Minister introduced a simple system for taxing dividend by deviating from the orthodox views on taxing income. He was considered market friendly and his budget was praised as a `dream budget.' Seven years later, when he tries a similar exercise and logically extends the principle of developing a simple tax system on capital gains, the market reacts negatively. The market hopes that he will rectify some of the anomalies that are natural whenever such innovative things are tried. Here is an insight with facts and figures to show that the new tax system is really beneficial to investors at large.

Tax on capital market transactions is a highly controversial issue all over the world. Arguments against double taxation are not new. The argument against double taxation is that business income taxed once should not be taxed again in the hands of investors. The governments of several countries do not buy this argument. Their contention is that corporates are a separate entity and should be taxed on their income and investors, when they receive dividends, should be taxed again. A few countries like the U.K. have the imputation tax system which overcomes this legal notion of separate entity, but such a scheme will be difficult to administer in the Indian market due to a large number assessees and the additional work involved for such a system.

In 1997, Mr. Chidambaram introduced a new scheme, which was received fairly well by all the sections of investors. Instead of abolishing the double taxation, he shifted the point of tax collection on dividend from investors to the company and introduced a dividend distribution tax.

Administratively, this is much easier than the complex system followed for a long time. A few attempts by his successor Yashwant Sinha to revert to the old system met with negative reaction from the market.

Dividend tax can be seen as a flat tax rate on all dividend income irrespective of the status of the recipient. The logical extension of dividend tax is a simple tax structure on capital gains. In order to understand the issue and complexity involved in capital gains tax, it is necessary to briefly discuss the existing tax structure on long-term capital gains relating to capital market transactions. Long-term capital gains are currently taxed at a flat rate of 10 per cent but the problem is differential tax treatment for different kinds of investors. For instance, approved FIIs are exempt from capital gains tax. There was a move to remove this exemption of FII in 2000 but the fear of FIIs stopping investments created negative feelings and there was no further move to simplify the tax system. It is an unfair advantage for FIIs compared to domestic funds as FIIs invest in India not out of charity but to make money.

Impact on FII inflows

By introducing dividend tax, Mr. Chidambaram has enabled levy of tax on dividend paid by Indian companies to FIIs and hence removed distortions created by tax-haven countries. (This author had argued earlier in a Business Review article (April 20, 2000) that a turnover tax on capital market transactions would plug the loophole. As long as the tax is kept low, there need be no fear of FIIs stopping investments in India. Based on past data, FIIs may end up paying Rs. 75 crores (about $15 million) on their average gross purchase of Rs. 50,000 crores ($10 billion). It is to be seen whether the burden will make FIIs withdraw or slowdown their investments in India. Since FIIs are anyway not required to pay capital gains tax, the Finance Minister at best can exempt them from this taxation if he sees there is an overall positive impact to the country. It may not be a right strategy in the long-run for the country to attract FII money through incentives. Such flows must come from making India Inc. a more attractive destination for investments.

It is difficult to justify tax on capital market transactions but it is equally difficult to justify a tax on capital gains. After all, capital gain is the outcome of retained profit and expected future potential arising out of such retained profit. Since profit is already taxed at a hefty tax rate, what is the merit of taxing such future profits which anyway will be taxed again when earned.

Thus the issue is to look for simple schemes that can remove the complexity of tax administration. For instance, why should tax exempt investors welcome dividend tax, which is actually an additional burden to be borne by shareholders but through the company? Are our investors not familiar with the impact and irrationally behaving by welcoming dividend tax? Not necessarily true.

Dividend tax brings down the overall cost of capital, whose benefit is enjoyed by everyone. Further, the nuisance of keeping account for paltry dividend receipts, taking it to tax consultants to work out exemption limits and then paying tax on the same has been removed. This is a real relief that an average investor wants and tax on capital market transactions gives such relief to investors. The only thing an investor would expect is that such relief is not given at a high cost.

There is an argument which predicts that the trade volume on day-traders account will be affected because of the new tax. It is too early to make such a guess. It was widely expected that volume in the stock market would dry up when carry-forward (badla) transactions were banned and again when the automatic lending and borrowing mechanism (ALBM) was withdrawn. Though these had some impact on volume initially, the volume picked up once the market sentiment driven by fundamentals improved. NSE data show that the value of stocks delivered on total turnover increased from an average of 14 per cent in 2001-02 and 2002-03 to 20 per cent in 2003-04. Such an increase is not on account of decline in turnover and actually daily turnover saw 80 per cent increase in 2003-04. It is open knowledge that such huge trading volume is restricted to a few select stocks. There are very few day-traders who create liquidity on stocks, which really require liquidity. Further, stocks on which day-traders create volume have low floating stocks with high promoters' holding or MNC holding or FIIs and other funds holding. At times, they create volatility when there is excessive trading on such low floating stocks, which in turn create further volatility in the market. Shrinkage in volume on such stocks is not expected to materially affect the liquidity position of the market.

If the new tax is likely to take away such super liquidity of a few select stocks, which actually creates volatility in the market, it is actually a major incidental benefit of the scheme.

Thus the Finance Minister can wait and see whether there is any major decline in volume and also whether there is any major impact on the liquidity position of the market. After all, he is also interested in volume since his tax collection depends on volume. Actually, at this point, his interest on stock market volume is more than that of many other participants in the market for this reason.

The last issue to be resolved is whether this 0.15 per cent tax is really too much for investors. Those who are familiar with the Indian stock market will vouch that the transaction cost for delivery as well as non-delivery based trading through the `badla' system used to be as high as two per cent and such brokerage was levied on turnover on both sides (purchase as well as sales). Further, there was a stamp duty for registering the stock and it was levied on the basis of turnover. Thanks to the initiative of the Government in automating stock market operations and introducing the `demat' system, which removed stamp duty for transfer of stocks, the transaction cost has come down substantially and today it is much lower than 0.5 per cent for delivery based transactions and further lower for `trading' transactions. The cost of capital market transaction in India is also one of the lowest in the world.

When investors were happy under the old system and paying 2 per cent on one-side transactions and another 0.5 per cent for registration, the complaint that 0.15 per cent is too high looks shallow. If there is any reduction in trading volume, it may affect the profitability of the brokers, which may call for a reduction in the number of brokers or increase in the transaction cost. In a competitive environment, it is up to the market to decide which one is desirable.

Loss of a few jobs in broking firms or decline in their high level of profitability need not be an issue to be considered while taking decisions on innovative tax schemes that benefit several millions of genuine small and long-term investors.

At best, the Finance Minister can assure the market that he will review the tax system next year based on the feedback and experience and use the opportunity to gather the views of small and long-term investors as well as other investors. Most investors will agree that the new tax system is a win-win proposal for everyone.

At the same time, it is necessary to significantly reduce the tax rate for debt instruments. Since derivative instruments (options and futures) are structured for a period less than one year, there is no question of long-term capital gain and hence these transactions should be completely exempted from turnover tax. The profit arising out of derivatives is anyway treated as short-term capital gain and attracts normal tax and it is unfair to tax them one more time. In other words, the new tax system should be seen as a simplified tax scheme in lieu of long-term capital gains without hurting liquidity to any great extent.

(The author is Professor and Chairperson, Finance and Control Area, Indian Institute of Management, Bangalore)

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