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Problems of the Transactions Tax

Omkar Goswami


Few in the fraternity would disagree about the skills of James Tobin as an economist. After all, one doesn’t win a Nobel Prize without being among the very best. Unfortunately, even the best practitioner can have the odd quirk. The Tobin tax happens to be one of them — which we in India are in the process of legislating as the transactions tax on securities trade.


Although James Tobin wrote hundreds of research articles that were published in internationally reputed academic journals, the Tobin tax was not one of them. Tobin was a macroeconomist and not a specialist on corporate finance or capital market. His idea of imposing a small tax to put a bit of “sand in the wheels” of capital market transactions — ostensibly to dampen speculative trades — was a stray, almost whimsical idea, which he didn’t formalise into a rigorous theoretical or empirical argument. It was an untested  hypothesis which, given the signature of Tobin, developed a stature greater than what it ought to have been. In fact, the few serious studies on the Tobin tax prove that it raises the cost of capital.


Since policy makers and budget mandarins generally don’t have the inclination to digest the pros and cons of economic theory, and since the Tobin tax is easy to collect, a few countries have imposed this on their capital markets. However, even in these odd instances, the tax generally excludes trades in options, futures and derivatives, and is levied at a rate far lower than the 0.15 per cent proposed in Budget 2004-05.


To me, any transactions tax on securities trade is a bad idea. Efficient capital markets need both depth and width. In other words, they need a sufficient number of diverse debt, equity and derivative instruments, as well as large volumes of trade and liquidity. Trade volumes and liquidity are provided by the arbitrageurs — the very short term, often intra-day, traders who leverage extremely temporary arbitrage opportunities to trade in underlying securities as well as and derivatives for wafer thin margins. By doing so in large volumes, they provide the necessary liquidity and help reduce volatility by smoothening prices.


Moralistic outsiders will, doubtless,  deride arbitrageurs as “speculators”. But anyone who understands capital markets will tell you that arbitrageurs are vital to the health of market — they represent the grease that oils the wheels of the bourse.


What the proposed transactions tax has done is to significantly increase the cost of this vital ultra-short term trading. Take the government bond market for instance. In a very good day, a trader would be lucky to net 2 basis points (0.02 per cent) on the day’s trade. It would be the same for most widely traded derivative instruments. Hence, it is not the margins but the volumes that make such trades worth the while. To levy a 15 basis point tax on such trade is akin to shutting this activity altogether. Not surprisingly, the few countries that do levy transactions tax — such as Australia and Singapore — not only impose a much smaller rate but also exclude government bonds, most debt instruments and derivatives, futures and options from the net. 


If he could, Mr. Chidambaram’s best move would be to restore the old short term capital gains tax and remove the transactions tax in one go. However, I gravely doubt whether he will do that. Therefore, he will possibly significantly reduce the transactions tax rate on debt instruments, derivatives and options, while maintaining the 0.15% on equities. That would needlessly distort trading. Besides, once you have a tax like this on the statute books, you can be certain that there will be a great  temptation to tinker with it every now and then to squeeze extra revenue.


The absurdity of all this is that the transactions tax was mooted by foreign portfolio investors when Mr. Chidambaram visited Mumbai prior to the budget. In their desire to get rid of the short term capital gains tax, they were all too keen to propose something else — which they did without much thought. And the FM happily took the bait. Didn’t they know that it is never a good idea to suggest any new tax proposal to any Finance Minister? Silly boys!


Published: Business world, April 2004


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