Amid recent debates among lawmakers, regulators, economists and industry practitioners on whether we should Make in India or Make for India or Make India, there is near unanimity on Using India, i.e., better use of India’s large household savings for more productive purposes. One such productive use is to channel household savings through the capital markets to private enterprises for growth and employment generation.
Yet, it is well established through repeated annual surveys of the Securities and Exchange Board of India (Sebi) that there is a severe distrust and suspicion of the stock markets among most Indian savers. Since 2001, for every additional Rs.100 gross domestic product (GDP), a mere Rs.1.50 was invested in the capital markets by savers while Rs.8 was spent in buying gold and Rs.18 went to savings bank deposits. Unintended consequences of certain past policy actions have served to exacerbate this trust deficit with equities among household savers. A simple fix can potentially go a long way in bridging this deficit. Ending the bizarre securities transaction tax (STT) structure is one such policy action.
When confronted with a choice of either investing in shares or speculating in derivatives in the stock markets, the current STT structure gives overt incentives to the average Indian saver to speculate instead of invest. STT for investing in shares for the long term is 0.1% for buyers and sellers, while for speculating through futures, the buyer pays no STT and the seller pays a much lower 0.01%. The transaction tax for day trading and derivatives trading through futures and options is far lower than for long-term investing.
This is a perverse incentive structure, notwithstanding market participants’ arguments about potential profit margins on derivatives being much lower than those in case of equity investments.
Tax on capital markets transactions was introduced by former finance minister P. Chidambaram in his 2004 budget speech to compensate for the loss of tax revenue from eliminating long-term capital gains tax in equities. Sebi estimates show that from 2004 to 2013, this transaction tax structure yielded anywhere between Rs.2,000 to Rs.8,000 crore annually in revenues to the government, accounting for between 0.06 to 0.2 percentage points of GDP.
On a first principles basis, the introduction of an STT by Chidambaram was a sound proposition to encourage long-term investment and discourage frequent trading while minimizing loss of tax revenue. If only he had also heeded the embedded warning signals of the devil in the details of the transaction tax structure that has blatantly encouraged speculative trading over investing.
Derivatives trading volume in India’s stock exchanges have grown at an annual compounded rate of 67% vis-à-vis share trading volume growth of 15%, since the introduction of STT in 2004. Annual derivatives’ volume in India is more than 16 times that of share trading, one of the highest ratios in the world, most of which is speculative and economically unproductive.
The current STT structure, though not singularly responsible, has certainly exacerbated this dramatic shift in volumes from investment in shares to speculation in derivatives over the last decade. This unique speculative character of the capital markets dominated by speculative traders trading frequently in complex derivatives aggravates mistrust and kindles nervousness among desirous first-time investors.
Financial economists in academia and think tanks argue for unfettered trading in derivatives in the garb of market efficiency and liberty. The more immediate need is for companies to be able to access capital markets to raise capital for growth and creating jobs. Foreign investors aside, the road also needs to be paved for the millions of domestic savers to overcome their fear and suspicion of capital markets. A more rational STT structure that brings in parity in transaction taxes across investment and speculation and does not nudge capital towards speculative trading will be an important first step.
The current structure can be reformed to an incentive-neutral structure that taxes both the buyer and seller of shares and derivatives at the same rate. This new structure will at worst be tax revenue neutral and more likely add to overall tax revenues in the near term, since derivatives volume is much higher than share trading volume.
Published on 22 February, 2015 in Mint