March 18, 2016
Photo: Pradeep Gaur/Mint
When Jaitley announced an increase in securities transaction taxes on equity options from 0.017% to 0.05%, he was imposing a ‘Pigouvian’ increase
Perhaps unknowingly, finance minister Arun Jaitley doffed his hat to British economist Arthur Pigou during his budget speech. “Pigouvian taxes”, based on Pigou’s seminal 1920 classic The Economics of Welfare, are a special category of taxes levied to neutralize negative externalities such as social costs of transactions. When Jaitley announced an increase in securities transaction taxes on equity options from 0.017% to 0.05%, he was imposing a “Pigouvian” increase. This is not a tax hike that can generate significant additional revenues for the government. Instead, this deceivingly large increase (200%) in transaction taxes for trading in equity options is an attempt to neutralize social costs of perverse incentives for capital market participants.
An investor who buys shares of Infosys Ltd, say, worth ₹ 1 lakh on the stock exchange currently pays ₹ 100 as transaction taxes. The seller of these shares pays the same amount. Alternatively, if one chooses to speculate on the price of Infosys shares going up or down through a put or a call option, the transaction tax is only ₹ 17 to the seller of these options and the buyer pays no taxes. It is not hard to see how this tax structure can be distorting by nudging market participants towards speculating through options vis-à-vis investing in shares.
This, in essence, has been the inadvertent and unintended consequence of the securities transaction tax structure, introduced in 2004. In the decade since 2004, the number of equity options contracts traded on India’s exchanges has gone up 150 times, while the number of shares trades has only doubled. Options trading accounts for almost all (95%) of the growth in trading volumes since 2004. To add to these perverse transaction tax incentives, the unique mix of low option contract sizes and short tenure attracted more retail speculators to the capital markets than genuine hedgers. Speculators only tend to attract other speculators and within a decade, the Indian capital market was transformed into a den of retail speculators with severe social costs of adverse selection.
In effect, first-time investors and other retail savers have stayed away from the capital markets that are dominated by retail punters. This is akin to a food court turning into a bar zone because the alcohol is cheaper than the food. It is bound to attract only those that indulge in drunken revelry, not families that want to eat out. To be sure, this is not to judge drunken entertainment vis-à-vis eating out. This analogy is to merely highlight the social costs of adverse selection imposed by skewed transaction taxes that attract sophisticated speculators and drive away first-time investors.
A well-functioning stock market is one that is designed to channel household savings into productive uses that can generate jobs in the economy. India’s stock markets have utterly failed in this mission. Just as per capita gross domestic product grew three times and the BSE Sensex rose five times between 2004-14, Indian household savers shunned equities and bought 18 times more gold than shares. Cultural reasons for gold aside, the speculative nature of India’s equity markets have played a catalytic role in this aversion to equities of the average Indian saver. The skewness in the transaction tax structure played a significant role in this distinct speculative characteristic of India’s capital markets.
The finance minister’s proposal to increase transaction taxes on options is to be viewed and judged in this context. The intent behind this increase in transaction tax on options is to offset social costs of excessive speculative trading. Some financial economists argue that this increase in transaction taxes is deceptively large since its marginal impact is still very minimal. The taxes are still charged only on the premium amount of equity options and not on the strike price. Since premium amounts tend to be a fraction of the strike price, the increase in the percentage of taxes on premium values may still not be meaningful enough to change behaviour. To add, this increase still does not achieve parity in transaction taxes between investing in shares and trading in options. However, it is a clear signal from policymakers about the need to curb excessive trading. One hopes this “Pigou” trick works out.
Praveen Chakravarty is a fellow in political economy at IDFC Institute, a Mumbai-based think tank and a former CEO of an investment bank.