Lost in taxation

The markets are celebrating the partial drawback of the securities transaction tax STT proposed in the budget. Their response is based on ...

The markets are celebrating the partial drawback of the securities transaction tax STT proposed in the budget. Their response is based on the drastic tax reduction for day traders, exemption for sale and purchase of bonds and the announcement that the STT on non-deliverables can be used for set-off against tax paid on speculative business income. Not just that, the long term capital gains tax on exchange traded securities which the STT sought to replace remains scrapped; the short term capital gains tax rate has been slashed to 10 per cent. No wonder brokers are ecstatic and liquidity has been restored.

While this is good news, the new structure of differential taxes creates a new phase of 8220;industrial policy8221; for financial markets. Unfortunately, even after rates have been reduced for some segments of the market, it does not change the fact that the STT remains an essentially distortionary tax, proposed, not on grounds of equity or efficiency, but for ease of collection. Through differential rates the government is now in the market, favouring some sections of the market it believes should be encouraged, such as the debt market, and discouraging others. Now the government will be able to tweak tax rates and provide exemptions to some market participants. The movement towards a structure where tax policy is used to create distortions in the market according to whom the government listens to, is dangerous policy. It will start a new phase of lobbying. It will create new pressures for the next ten finance ministers and there8217;s no guarantee they will all respond rationally.

The second puzzling issue is the impact of this rollback on revenue. In his budget speech, Finance Minister P. Chidambaram indicated clearly that the STT would be revenue neutral. The STT was accompanied by the reduction in revenue collection from the capital gains tax. While the exact impact of the proposals was not placed before Parliament, the new tax was expected to earn Rs 5,000 crore. The revenues from the new differentiated tax structure are expected to drop to Rs 1,000 crore. This means the proposals are no longer revenue neutral. In the Parliament discussion on the rollback, the impact on budget estimates for revenue collection should have been specified. Since the Fiscal Responsibility and Budget Management Act requires that the government present a medium term fiscal strategy, the effect of the change needs to be clarified. Not just for this year, but for the future as well.