Friday, January 13, 2006


It is budget season in India, and debates about taxation are once again in the air.

Everybody loves to hate the new treatment of `fringe benefits'. Firms are unanimous in being unhappy about the mechanics of the "fringe benefit tax" (FBT). From first principles, what one would like is a system which measures the complete income of all employees accurately, and applies the same tax schedule to all of them. In this cases, whether a person is paid Rs.50,000 per month as a flat salary or whether Rs.20,000 of that is delivered as a zero-rental apartment, the tax rate should be neutral. Critics of the FBT need to fully articulate a non-discretionary mechanism for solving this problem. To the extent that the FBT has pushed firms towards all-cash wage packets, that's a Good thing, and is partly a useful consequence of the FBT. Ila Patnaik has an interesting article on this in yesterday's Indian Express.

In my mind, the picture is very different with the `Securities Transactions Tax' (STT). Business Standard has an excellent editorial on this. This is a tax which is simply wrong. The job of a financial sector is to deliver low transactions costs for trading. Low transactions costs imply higher market efficiency, which is the end-goal of all finance.

The STT stands at 10 bps for cash (delivery) trades, 2 bps for cash (square off) trades and 1.33 bps for derivatives trading. These are huge numbers. Consider a vanilla spot-futures arbitrage for the Nifty futures. Normally, the transactions costs would be driven by the impact cost, which is typically 10 bps on the spot and 2 bps on the future. The STT then implies a huge jump in the frictions of trading - even for this simplest strategy (spot-futures arbitrage). If you tried to run an options book, based on a delta-neutral dynamic strategy, which ran up a lot of trading, the picture would be much worse.

The STT also does something deeply wrong by exempting many parts of finance (e.g. the bond market or the commodity futures market). Given the large size of the STT, this generates huge distortions of activity away from taxed sectors towards untaxed sectors. This is a bit like the customs problem. The best rate for customs duty is 0. But if you have to have a non-zero customs duty, the best system is to have a uniform rate for all markets.

The STT really taps into the deep intuition of a person vis-a-vis finance. Some people think that financial markets are to be mistrusted, that more trading is dangerous, that there is such a thing as markets that work too well. To this instinct, the STT is a good option, for it throws sand in the wheels of finance. To others, like me, the name of the game in financial sector policy is how to obtain more liquidity - not less. If we had wanted less liquidity, why did we bother trying to build modern markets?

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