This is Budget time, and contentious issues would once again be brought back to the table. One such issue is the transactions tax on securities and commodities. A number of analysts and researchers have written on this, largely opposing the move on Commodities Transaction Tax (CTT) as well as arguing for removing (or gradually reducing) the existing Securities Transaction Tax (STT).
SECURITIES TAX DAMAGING
The rationale for introduction of STT in 2004 was mainly to track transactions and minimise tax avoidance. This move might have helped at that point of time, as tax infrastructure was weak, and helped mop up higher revenues with higher bouyancy. The other rationale for introduction of transaction tax is that it is expected to reduce speculation and volatility, and help markets discover efficient prices.
However, in the empirical literature, there are no widely agreeable conclusions that support such an argument. At least, it is very difficult to establish that post-STT in India, both speculation and volatility have reduced in Indian stock markets. But the adverse impact of such taxes on trading volumes has been established by many studies.
This is found to have resulted in reduction in tax base as well as tax revenues. At the same time, it discourages small savers and new participants from entering the market. Compared with 2004, now India has a much better tax infrastructure. It is not clear how far STT can still help reduce tax avoidance. This calls for a rigorous cost-benefit analysis of such policies.
Recently, banks and others have argued for introducing CTT, so as to provide a level playing field among all segments of financial markets. This would be more ruinous. While acknowledging that banks are not allowed to enter the commodities market — although they should have been — the alternative cannot be introduction of CTT.
There is no clear justification for introduction of CTT in India. The role of commodities markets is quite different from securities markets; the former is more linked to the real economy than the latter.
REAL ECONOMY LINKAGES
Unlike securities market, particularly the secondary market, commodity markets play a major role in price discovery, and at the same time help both producers and consumers hedge their risks, which are the basic functions of any futures market. They also help formalise the otherwise hugely informal commodity markets that were deriving inefficient prices and eroding the tax revenue base.
In India, although the volumes in the commodity market have increased over the period, the participants’ base is still low. The transmission mechanism of prices and risks from the futures market to producers are still evolving. With regular intervention in the market (which is not there in securities market) and the low base of informed participants, these markets need to be developed further with a better regulatory framework.
Moreover, this segment of the market is already disadvantaged by issues such as the absence of tax exemption (both on income and capital gains), limited participation, among other things. The median tax on the commodities traded is at 19.55 per cent, which is very high. Any introduction of CTT at this stage could potentially result in undesirable and not-so-efficient outcomes.
FOOD INFLATION EFFECTS
High food inflation since 2007 has been attributed to so-called speculative trading in commodities market. Hence, it was argued that there is a case for introduction of CTT. The Abhijit Sen committee, which was constituted to look into this issue, suggested that the role of futures trading on spot market around that time was inconclusive.
This actually suggests that futures and spot markets are not related, which defies the anticipated and fundamental role of commodity futures. Our own analysis based on recent data (CDE-DSE Working Paper-219) shows that the presence of futures market indeed reduced the price volatility and ensured smooth transmission of exogenous shocks to spot markets.
Further, both markets are found to be co-integrated, satisfying the basic fundamental objective. Many studies have shown that the recent surge in food inflation is largely due to structural factors, some are policy induced, and not due to the futures market. With this background, calling for ban on trading of some commodities and advocating CTT defies logic.
The Exchanges, on their part, need to take up the responsibility for enhancing financial literacy, help in widening the market and smoothening information flow.
To sum up, with a robust tax infrastructure, any transaction tax (either STT or CTT) that is intended to contain tax avoidance would end up with adverse consequences. This is more so in the case of CTT, where markets are still evolving and have a larger role to play than securities market.
Given current economic conditions, where the confidence in the financial markets are low, it is important to provide confidence-building measures that broaden the market base, and encourage savings to be channelled to the real sector through financial markets.
It is also time for bringing in well-regulated instruments, rather than introduce hurdles in financial sector development. Introduction of CTT would increase costs and constrict the market.
(The author is Professor, NIPFP, New Delhi.)