Securities transaction tax (STT) is a form of financial transaction tax (FTT) that has an equal number of proponents and opponents. The earliest proponents of FTT, Keynes and Tobin envisaged using such taxes mainly as a tool to curb speculation. But in recent years, many countries have used such levies to raise revenue. The ease of tax collection and zero possibility of tax evasion are some of the arguments in its favour. Opponents cry hoarse over such issues as reduction and migration of trading volumes.
Global experience
Many countries besides India, such as China, Indonesia, Italy, South Africa, South Korea and the UK charge tax on cash-based equity transactions. These taxes are applied on the market value of the shares and can vary between 10 and 50 basis points.
Many other countries have also experimented and done away with with FTTs in the past. The US eliminated STT in 1966, Germany in 1991 and Japan in 1999. Australia removed stamp duty on share transfers in 2001 and France removed STT in 2009. The main reason cited for removal of such levies was concern that funds will move out of the country stunting development of domestic capital market, given the increased globalisation of investor base.
India is also exposed to the risk of foreign institutional investors migrating to other markets with lower transaction cost. FIIs are a dominant force in our market, contributing 20-30 per cent of the daily turnover value. But FII turnover has been declining since the introduction of STT. Their activity in the cash segment is down 21 per cent over the last five years. Increase in volume of Nifty futures on Singapore stock exchange (Singapore does not impose transaction tax on equity futures) also underscores this view.
STT on derivatives
Though many countries have imposed STT on delivery-based transactions, such taxes on equity derivatives are rare. Apart from India, the UK and Taiwan are the only other notable countries that tax equity derivatives.
Why are countries more reluctant to tax derivative transaction? According to IMF working paper, authored by Thornton Matheson, imposition of transaction tax creates a ‘no trade zone' around the purchase cost. Investors will not respond to changes in asset price within this zone because the returns will be less that the transaction tax incurred. This reduces trading volumes. Another reason is that the transaction tax cost for a trader is a much larger portion of the returns when compared to a long-term investor who can play for larger gains. Since capital market or the cash-based trading segment is supposed to be populated by investors with a longer investment horizon, they can bear the impact of these taxes better. This explains why most countries shy away from taxing derivatives. India would also do well to follow this practice.
Reduction in liquidity
Empirical studies have proved that higher transaction tax does reduce trading volume. Umlauf (1992) found that 100 per cent increase in Swedish STT in 1986 resulted in 60 per cent decline in 11 most actively traded stocks on Stockholm exchange. Baltagi and other (2006) found that when China increased in STT from 0.3 to 0.5 per cent in 1997, trading volumes declined by one third.
What has the Indian experience been with relation to volumes? As the accompanying table shows, cash as well as derivative volumes on the NSE are declining over the last five years. The value of shares traded in the cash volume on the BSE has also witnessed a similar contraction. While part of this shrinkage can be attributed to indifferent market conditions, STT cannot be ruled out as a cause.
Shift in volumes
Migration of volumes across markets and borders is another fall out of taxing securities trades. Umlauf (1993) and Froot and Campbell (1994) found that the Swedish transaction tax resulted in trading shifting from Stockholm to London stock exchange. Similarly, studies have shown that reduction of STT in Taiwan resulted in volumes moving from Singapore to Taiwanese exchange.
The increase in volumes in exchange traded currency futures and commodity derivatives over the last three years in India could partially be due to the impact of STT on equity derivatives. But it needs to be noted that both these segments are at a nascent high-growth stage.
That can explain the sharp increase in volume in these segments too. A greater concern is shift in FII trading out of the country as discussed above.
Need of the hour
India has among the highest transaction costs globally on equity transactions and a significant portion of this is due to STT. It is also among the few countries that impose both stamp duty as well as STT on equity transactions. Obviously the government is out to milk equity investors to the utmost extent. And, then, the investors have to shell out fee to support the market regulator SEBI as well.
Expanding the base for STT to untaxed segments such as commodities or currencies is not the solution. Financial markets in our country, be it equity, commodity or currency, are still in the growth phase. Imposing transaction tax on these will only stunt their growth. And then there is the danger of FIIs shopping for lower-cost destinations too.
The government needs to decide whether it wants a healthy rapidly expanding equity market or a moribund stagnating one.
The fate of the divestment agenda this fiscal and the woeful performance of Indian equity in 2011, even as other markets were thriving, should be enough to give a wake-up call that things are going wrong here.
The first step can be removing STT imposed on equity derivatives. This can be followed by phasing out STT on capital market segment as well.
Loss in revenue of Rs 7,500 crore from STT may be compensated by many other long-term benefits — divestments can be made at higher prices, forex reserves may remain heathy and Indian companies may enjoy easier availability of equity funds.
The Government can also improve enforcement of capital gains tax collection to mitigate the impact of reduced STT revenue.