Don't tax commodity markets further

The Government's proposal to impose a uniform stamp duty of 0.005 per cent on all exchange-traded transactions across the country is a retrograde step. The timing of the proposal is inappropriate, in view of the high rate of inflation, particularly in commodity prices.

Although the proposal is being explained as an initiative to rationalise the tax structure for financial transactions, a close scrutiny indicates that the policymakers have imposed this tax indiscriminately on different segments of the financial market, irrespective of their respective roles.

Commodity markets, which usually have a direct bearing on inflation as they deal in food products and core industrial inputs, have been treated in a similar manner as other components of the financial markets, such as the stock market.

Imposition of an additional stamp duty will unnecessarily inflate the cost of transactions, leading to a fall in market volumes and liquidity. The commodity sector in India is already heavily taxed, with imposition of multiple taxes by the Central and state governments.

In the physical market, commodities are subject to a plethora of taxes — from Mandi tax and VAT to excise duties.

For instance, almonds are taxed in Mumbai at 12.5 per cent VAT, 0.8 per cent Mandi Tax, Rs 100 per kg import duty, 3 per cent education cess and 0.2 per cent Navi Mumbai Municipal tax. Almost similar tax structures exist for rubber, cotton, copper and aluminium.

In the futures market, regulatory tools for risk management, such as heavy security deposits, high initial and special margin requirements impose burdensome (even if necessary) transaction costs for trading in commodity derivatives.

COMMODITY AND STOCK s

Commodity and capital markets are different in purpose and character. The commodity futures market is an adjunct to the physical market and performs an auxiliary function in the efficient and orderly trading of commodities.

This is in stark contrast to the stock market, which exists primarily for the allocation of long-term capital from savers to corporate capacity creators.

Unlike the stock market, a commodity futures market is primarily a hedging market. Though it isn't necessary for transactions to always culminate in delivery, deliveries need to be arranged to maintain a parallel or near-parallel relationship between the physical and futures market prices, to facilitate efficient hedging.

On the one hand, farmers, merchants, stockists and importers hedge their stocks and forward purchases against a possible price fall.

On the other hand, processors, manufacturers, exporters and even traders with forward sale commitments require hedging against probable adverse price increase. Hedging merely reduces their unforeseen losses in the physical markets and doesn't yield good profits.

A stamp duty on transactions will increase the cost of hedging, hindering the risk management process. Price discovery by a futures market has a much more important role to play in commodities than in securities. Commodity futures prices serve as reference prices for physical market transactions in forward contracts. Security futures prices have no such equivalent role.

Physical market functionaries in commodities are keen to know the true equilibrium prices, as defined by underlying supply and demand. These prices help them to prepare production and distribution plans.

What farmers and consumers actually need are stable commodity prices. An active commodity futures market seeks to achieve precisely that by reducing seasonal and unusual cyclical swings. A stable stock market, in contrast, is anathema to stock exchange speculators as well as investors.

Stamp duty is prone to create a divergence between the physical and derivatives markets for commodities.

Such divergence will hamper the hedging efficiency, and the process of price discovery.

REVENUE GENERATION

The proposed stamp duty of 0.005 per cent would be higher than the highest stamp duty currently imposed by any State Government.

States such as Haryana, West Bengal, Tamil Nadu, and Andhra Pradesh that haven't levied stamp duty on commodity derivatives trading are witnessing a sustained rise in growth rates of commodity trading volumes during the past few years.

In 2010-11, commodity futures volumes in Haryana, West Bengal, Tamil Nadu, and Andhra Pradesh grew by a healthy 392 per cent, 89 per cent, 66 per cent and 50 per cent, respectively. Rajasthan, with very low stamp duty rates, has witnessed consistently rising volumes and higher revenue collection.

High uniform stamp duty is likely to reduce trading volumes, cause trades to move from well-regulated exchange-traded derivatives markets to under-ground, illegal, ‘dabba' market. Moreover, it won't produce the desired revenues for the government.

Pavaskar and Ghosh (2008) ( Commodities Transaction Tax: A Recipe for Disaster, Economic and Political Weekly, 43 (39), 17–20 ) analyse the revenue implication for the government of a 0.017 per cent transaction tax.

Using the base case of turnover in 2007-08, they find that while there is a 20 per cent fall in trading volume as a result of the tax the increase in revenue to the government is a paltry Rs 47.12 crore.

If the trading volume declines further, far from adding to the Exchequer, the government will lose more revenue than what it fetches from the tax.

If at all it is necessary to impose the duty, its rate must be modest, keeping in mind the implications it may have on food and general inflation.

The authors are Professors, Department of Financial Studies, University of Delhi.

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