Why commodity transaction tax must go

If there is one tax that has done more harm than good in India, it is commodity transaction tax. Perhaps, this is because it was introduced for the wrong reason. While typically such taxes are levied to curb excessive speculation or to garner tax revenue, the Centre used CTT as a tool to make trading shift from commodity to equity futures.

CTT has achieved its intended objective. Stock futures volumes are growing at an almost unhealthy pace while commodity futures volumes have reduced considerably. But is that what the Centre wants?

With the growing focus on making metal and bullion producers use domestic exchanges for hedging, there is a need to revive the dwindling volumes in these segments fast. Hedging volume alone is insufficient as arbitrageurs and traders are required for providing market depth. But these players are put off by the high transaction cost in India.

Also with the stock exchanges — who initially called for introducing CTT — also entering the commodity derivative space, there will be no objection from any quarter, if this unnecessary levy is withdrawn.

Unnecessary levy

It was in the Union Budget of 2008-09 that P Chidambaram first mooted the idea of CTT. At that time, the intention appears to have been to garner revenue from a section of the market that was growing at a brisk pace. The Budget proposal was, however, not implemented due to vociferous opposition of the commodity exchanges and traders.

In 2013 however, the lobbying by stock exchanges drowned the protests of commodity exchanges in the corridors of power. The stock exchanges argued that Securities Transaction Tax levied on equity derivatives had made transacting in stock futures and options more expensive and an unfair advantage was being given to commodity derivatives that were free from transaction tax until then. They were of the view that this was resulting in shifting volumes from equity to commodity futures.

It was once again Chidambaram who, in 2013, brought down the axe on the commodity traders, imposing CTT on non-agricultural commodities futures contracts at 0.01 per cent of the contract price. While most agri commodities were exempt from this tax, some processed commodities were brought under the purview of this taxation. In 2018, CTT has been imposed on commodity options too.

The impact

Financial Transaction Taxes — the category under which CTT falls — are double-edged swords. Keynes had used Securities Transaction Tax to curb excessive speculation on Wall Street in 1936 and Tobin had used this tax effectively in currency markets. But the experience in many other markets where such taxes were introduced has not been good.

A 100 per cent increase in Swedish STT in 1986 resulted in 60 per cent decline in 11 most actively traded stocks on the Stockholm exchange, according to a research paper published by Umlauf in 1992. Baltagi and others (2006) found that when China increased STT from 0.3 to 0.5 per cent in 1997, trading volumes declined by a third.

This has been seen in India too. Traded value of bullion contracts on the MCX declined 82 per cent between 2012 and 2017, after the introduction of commodity transaction tax.

Since trading volume was the highest in this segment, it witnessed the greatest impact. The decline in volume of energy and base metal contracts was a little less severe at 51 per cent and 35 per cent, respectively.

Interestingly, agri-commodity derivatives were also negatively impacted in this period, though agri futures were out of CTT’s ambit. While agri contracts on the MCX recorded a 60 per cent drop in volume, NCDEX’s turnover dropped 46 per cent in this period. Agri contracts were, however, also impacted by the NSEL crisis in 2013 and demonetisation in 2016.

While part of the volume drop can be explained by these events, fewer financial participants in non-agri segments could have also affected volumes here. Due to the lower volume, the revenue from CTT collection has been so meagre that it is clubbed with other income taxes in the Union Budget.

Of greater concern is the fact that shift of trading volume from commodity to equity futures may have led to undue volumes in the stock futures segment. After the imposition of CTT on commodity derivatives, stock futures volume recorded a steady increase, growing to ₹1,55,97,519 crore in 2017-18 from ₹40,74,670 crore in 2011-12; increasing 282 per cent. Index future volume on the NSE has recorded a more sedate increase of 34 per cent in this period. Single stock futures are the riskiest segment, with retail investors most at risk here.

Doing away with CTT

Introduction of CTT has, therefore, dealt a severe blow to volume of bullion, energy and base metal contracts traded on commodity exchanges while causing an unnecessary spike in stock futures trading.

While the Centre is right in trying to prod more metal and bullion producers to hedge on domestic exchanges, it also needs to turn its attention towards lack of liquidity on the exchanges. For hedging is not possible on exchanges where volumes are poor.

Financial participants such as arbitrageurs and traders, who have moved away due to the CTT levy, are needed to impart liquidity in any market. The Centre therefore needs to seriously consider removing the transaction tax on commodity derivatives.

The argument that large companies that need to hedge are unaffected by the additional levy may be true, but the smaller traders definitely find it crippling.

Besides, large hedgers will find price discovery weak if the market has no depth.

The commodity derivative segment is more important than equity because it helps commodity producers and other manufacturers manage their price risk. Since this segment is still at a nascent stage, burdening it with additional transaction taxes, which yield paltry sums to the exchequer, makes very little sense.

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