The imposition of a 0.15 percent transaction tax on all financial transactions has shocked all. The mystery is how this tax, discussed for a full month in the newspapers, with comments from FII’s and the brokers, and other experts, could have so jolted the participants. Everyone advocated it and nobody liked it. Is this possible? Yes – good idea, bad implementation.

I was an advocate for a transaction tax as a substitute for capital gains taxes. My recommendation was to reduce all capital gains taxes to zero, and have a differential turnover tax on market participants - in particular, .05 percent on deliveries and a 0.01 percent for futures (both buyer and seller to pay). Discussions with friends and bureaucrats evoked only one comment - that I was naïve. Their fear: give a Babu (and/or a politician) an easy method to raise taxes and the next thing you know is the tax has been raised - and raised, until there is zero tax revenue. A "easy" source of revenue, and the inclination is to kill the (Rs. 2000, 10,000 and 6000 crores for deliveries, day trades and futures respectively) golden cash cow. Sweden's experience with a transaction tax (TT) on securities in the late eighties is revealing; at the end of only two years, they decided to scrap the tax, and its in-the-dream-only revenues. If I had to do it all over again, I would not ask for a TT in India - certainly not until one is assured of the human capital in government. That is a long time before the dawn.

The Finance Minister, Mr. P. Chidambaram has shown immense intellectual courage to admit that the "implementation" of the turnover tax left a lot to be desired. He is willing to consider reasonable alternatives, as long as the tax is retained. Herewith, some suggestions and a method of deriving a "fair" tax across securities (debt, foreign exchange, derivatives, stocks, daytrades etc.)

Does India need a transactions tax? One of the biggest problems in India is that tax compliance is very low; only about a quarter of those people who should pay income taxes actually do so. In the case of capital gains taxes, the proportion is considerably lower - almost non-existent. Last year, market cap went up by Rs. 300,000 crores; assuming short and long term gains were equal, at an average rate of 15 percent for all gains, the government should have collected Rs. 45,000 crores. The entire personal income tax collection last year was less than this amount! Why? Because most of the tax gains are offset against tax losses which are sold by brokers for a small fee of 10 to 15 percent (of the gain). This has to be done in connivance with income tax officials because theoretically, a trade entered electronically appears both on the NSE records and the broker's records. It cannot be changed - except in government tax records for a small fee.

Thus, there is a strong efficiency argument for the imposition of a transactions tax - as a substitute for the capital gains tax, short-term or long term. With electronic trading, such a tax is easy to collect, is efficient, and (broadly) paid by those who make capital gains. However, it should be emphasized that in recent years, research has documented that the economic case for a capital gains tax is weak, if not non-existent.

So, there is no case for a capital gains tax. Assume there is a case. Under that assumption, the FM needs to be commended for his policy announcement - no long- term capital gains tax and a short-term gains tax of 10 percent. (Note the co-incidence between this rate and what the brokers charge for selling tax losses). Excellent policy, and one likely to increase revenue considerably, and in multiples of the Rs. 1000 crore that is presently being collected from such taxes. A major quibble though - why have the huge distortion of levying a short term tax rate of 33 percent if the gain is through derivatives rather than thru trades in the cash market? Such a distortion, to my knowledge, not only does not exist elsewhere but has not even been thought of by non- Indian Babus. I am happy to be corrected. Nor is there a case for a TT tax "since we do not have a VAT". But brokerages are already in the tax net of services, so imposition of TT is not a substitute VAT - it is just an extra tax.

Given that we need both a transactions tax and a short-term capital gains tax (a double taxation to equal that of dividend taxation), the only question remaining to be answered is: how should this tax be levied across different instruments. This is where the decision makers, the trigger happy socialists, have blown themselves away - and shown themselves to be considerably worse than incompetent. By levying the same tax of 0.15 percent on all trades (on day trades and futures, and debt and deliveries) they will ensure that the market will cease to exist, and their TT revenues become TTT - theoretical transaction tax revenues.

The TT should be so reasonable that it does not hurt volumes and liquidity. One such estimate is the SEBI transaction tax - every stock market transaction collects .01 percent "in the name of SEBI". "So that we can regulate you better". There is a total volume of Rs. 18,000 crores every day. At .01 percent, that is Rs. 450 crores annually, and since most market players do not even know about it, it does not affect the volume of transactions.

A more reliable and generalized approach of estimating the size of a transactions tax is via the value added approach. Brokerage costs for delivery trades average around 0.20 percent (institutions plus retail). Brokerage value-added is about 60 percent of revenue, so value-added is 0.12 percent of brokerage costs. The desirable VAT rate is 15 percent; thus, the desirable VAT on brokerage would be .15*.12 or .018 percent of the value of each capital market transaction. "Service" fees reflect value-added, and most likely the risk-adjusted level of gains. In the FX market, such fees are .0002 percent; in the debt market, they are even lower - .00005 percent. This indicates the random and bizarre imposition of 0.15 percent tax on all financial transactions!

Once a transaction tax is decided on for one instrument, then it can be derived for other transactions. Assume that the 0.15 percent tax on stock deals is acceptable. Minor quibble - it should be on both sides of the transaction, so let us accept .075 percent as "correct". This is approximately a third of brokerage costs. So the derived fair tax on all other instruments is one-third the value of brokerage. For futures (average cost 0.04) the fair tax is .013, for day-trades, .017 percent, for debt, .000017 percent etc. Note that before Malaysia abolished all TT, it had a TT rate on futures which was less than one- hundredth the tax on spot purchases.

At the above reasonable rates of taxation - 0.075 for deliveries (as per the FM's suggestion) and 0.015 for futures and day-trades, the government stands to gain about Rs. 1000 crores a year. This is revenue neutral, plus for law-abiding citizens (and FII's) it provides a level and fair and internationally competitive playing field. Further, with the 10 percent short-term tax, and a bullish stock market, revenue gains can be ultra positive and with even a 50 percent compliance, raise an additional Rs. 4000 crores, or 10 percent of the tax revenue presently collected in the form of all personal income taxes. A fair-fair win-win policy for the government, and the market.