The Hindu Business Line : A tax that can be unsettling

THE proposal to introduce a turnover tax has created a minor pandemonium in the market. Investors and traders are used to paying tax on profits, not on turnover. The Finance Minister's decision to impose such a tax is, ironically, not to curb speculative activity in the market. Rather, such a tax is imposed to enable smoother collection by the Income-Tax Department, as many do not pay capital gains tax on their financial market transactions. But that is no justification for introducing such a tax.

It is, however, moot whether the market is likely to suffer any far-reaching consequences as has been envisaged by many. Specifically, asset price efficiency may not be disturbed because of a possible decline in market turnover. The reason is that the market is a self-organised system. The asset prices may stabilise in the new market microstructure. But such a self-organised structure cannot be expected of the derivatives market.

Non-delivery trades: Scalping trades are expected to decline because of the turnover tax and a hike in service tax. But the point is that a substantial proportion of the day trades is by operators who manipulate prices. Asset price movements for these operators are not a random walk but follow a pre-determined path that they set. These day traders engage in scalping trades to lure gullible investors to the stock. How else can a stock gather momentum and drift in the direction that the operator wants it to?

The question is whether these operators will be able to move the asset prices without engaging in scalping trades. They may find it difficult in the initial days after the turnover tax is introduced, just like they faced a problem when the stock market shifted from weekly settlement to T+5 system. After a while, the market may find its equilibrium, perhaps, at a higher price level. If day-traders previously engaged in scalping trades for 3 points, they may now have to trade for 7 to 10 points to make such transactions viable. Of course, turnover may come down because of higher costs. This may lead to increase in brokerage commissions.

But that may not stop demand for financial assets in the market. The logic is the same as with petrol price hike. People do not stop consuming petrol because of a price hike. It is essentially a cost-benefit analysis. Those who need the benefit of comfortable travel will continue to consume petrol at higher costs. Those at the margin may cut their consumption.

Similarly, operators will continue to dog the market, contributing substantially to the day trading volumes. Those at the margin, the noise traders, for whom the asset price movements are a random walk, may reduce their trading activity. But that is unlikely to bring the market to a standstill. In fact, financial literature suggests that turnover tax improves asset price efficiency! This happens because such a tax imposes high cost on noise trading, thereby reducing excess volatility in the system.

Derivatives: Having said that, the Finance Minister has to seriously consider removing derivatives from the ambit of turnover tax. The reason is that scalping trades constitute a higher proportion of trades in this market. In any case, derivatives transactions do not attract long-term capital gains tax. So, imposing turnover tax will burden derivatives traders with additional tax.

Moreover, the contract-multiplier effect will be act as deterrent for widening profit points on scalping trades. Contract-multiplier refers to the units underlying each futures and options contract. The Nifty contract, for instance, has a multiplier of 200 units. Widening the potential profit points would mean a corresponding increase in stop-loss levels. The multiplier effect, therefore, increases the position risk. Day traders would rather trade smaller quantities; the ones at the margin will drop out of the market.

If turnover tax is imposed in the cash market and not in the derivatives market, noise traders at the margin are likely to shift to the latter. That will bring in asset price efficiency in the cash market. It is, however, important to keep a cash-settled market design for derivatives contracts. Otherwise, the impact of the turnover tax in the cash market may trickle into the derivatives market. This may prevent scalping trades in the derivatives market. In a desperate bid to earn their living, day traders, including noise traders, may shift to the cash market and unsettle the market microstructure — something our economy can do without.

(Feedback can be sent to bvenky@thehindu.co.in)

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