The Finance Minister P Chidambaram walked the rough road last week with one mission - to improve the fiscal health of the country - and remove major clogs, so that India Inc becomes a strong, resilient and well-oiled machine.

The Union Budget operation was well performed, and he did most that could be got out of a four-week preparation.

He however left behind a bitter-sweet pill - in the form of a turnover tax - which left the brokers seething and the stock markets crashing.

The reaction from the Indian bond and equity markets probably took the market regulator Securities and Exchange Board of India and the Reserve Bank of India by surprise, forcing an urgent dialogue on Friday last between the concerned parties.

As things stand, the finance ministry, including Mr. Chidambaram will meet brokers and bond dealers on Monday and Tuesday to resolve the problems.

Considering the larger change in tax structures - through the removal of long term capital gains tax - what makes the turnover tax such a big issue, enough to force the bond markets not to trade for four hours and angry day-traders to take to the street?

Turnover Tax: A Closer Look

Mr Chidambaram has introduced, what could be rightly called, a securities transaction tax and it is not in a wider sense a "turnover-based" tax.

The memorandum to the provisions relating to direct taxes - Chapter VII and Clauses 5, 24 and 25 - provide an explanation on this issue:

"With a view to simplify the tax regime on securities transaction, it is proposed to levy a tax at the rate of 0.15 per cent on the value of all the transactions of purchase of securities that take place in a recognised stock exchange of India. This tax shall be collected by the stock exchange from the purchaser of such securities and paid to the exchequer."

Thus what becomes clear is that it is a levy on every trade done at the stock markets, whether done through a phone-based broker or an online trading firm. Thus if someone were to buy, say for example, Reliance shares, in a transaction valued at Rs 100,000, he would pay a securities transaction tax of Rs 150 on that.

Further, as the finance ministry has clarified, this tax is a direct tax and will come into effect only when the Finance Bill is passed.

The New Tax Reforms: Benefits

The turnover tax has been introduced in lieu of the long-term capital gains tax. The removal of long-term capital gains tax and the reduction in short-term capital gains tax from 30 to 10 per cent is a huge positive for foreign investors not coming through the Mauritius route.

This was a major demand from FIIs and it will help make India one of the most attractive countries in terms of tax regime and can lead to incremental funds flows into the country.

For foreign investors, the most obvious advantage is in not being incorporated in countries like Mauritius, which have a double-taxation avoidance treaty with India. The transaction - or turnover tax - will be easy to collect as the tax gets deducted at the brokers' end and there are fewer speculative trades as there is a disincentive to trade frequently.

In the current tax regime, the accurate reportage of capital gains tax (long or short) to the Income-Tax authorities, was always a debate and speculative profits were rarely reported. Now there will be complete parity between FIIs and Indian investors and also domestic and foreign mutual funds.

Should investors be concerned - why are the brokers crying foul?

Impact on the equity markets

Analysts with leading domestic and foreign brokerage outfits - Credit Lyonnais, Prabhudas Lilladher, SSKI Securities and HDFC Securities - in their latest Budget analysis have warned that the immediate impact of the "turnover" tax is that liquidity will dry up at the equity markets. This is because at least 65-70 per cent of trading volumes at the cash markets are speculative in nature (and not delivery-based). The futures market transactions will also be hit by this levy.

Day traders and arbitrageurs will obviously be hit most as more they trade, the more transaction tax they pay. They will not be able to take full advantage of the reduction in short-term capital gains tax and will see their transaction costs going up.

The snowballing effect of lower volumes and a dry-up in liquidity is that retail investor sentiment is affected and they stay away from the market. Over a medium-term if this condition prevails, it would drive investors towards a completely illegal market -- referred to as the "dabba" market.

Then the government stands to lose out on tax/revenues and create more problems for the regulator in terms of price distortion and market manipulation.

Mohan Vijayan, chief of the BSE Brokers Forum said, "If the turnover tax is introduced in the existing form it will hit liquidity, volumes and the players in turn. We are finalising our proposal to be presented to the finance ministry. Our suggestion is either to reduce the percentage of tax or introduce it only on delivery-based trades and/or specific securities."

The "turnover" tax is such an impediment that the BSE brokers have for the first time joined hands with the ANSE (Association of National Stock Exchange Brokers), to tackle this issue.

Manoj Kakaiya, chief dealer, ULJK Securities, a BSE institutional brokerage said the introduction of the 0.15 per cent turnover tax will impact liquidity in the markets by making speculation expensive.

Sanjay Suratwala, dealer with BSE brokerage Dalal & Broacha said, "This is a new system. Whenever there is change, there will be resistance. The market will take few days to settle with the process and one should see the positives of the Budget sink in."

Impact on the bond markets

The bond markets shivered Friday last, with trading at a virtual halt until the finance ministry and RBI officials intervened. On Friday trading volumes fell sharply to approximately Rs 400 crore (Rs 4 billion) against the average daily volumes of Rs 3,500 crore (Rs 35 billion).

In the bond and gilts market, the introduction of a "turnover" tax will affect all fixed income brokers and make trading non-viable for most players. The issue is compounded by the fact that over 95 per cent of all deals are of Rs 5 crore (Rs 50 million) and above. Analysts say that banks wishing to buy government securities would have to pay anywhere in excess of Rs 75,000 – Rs 1,00,000 as transaction tax, besides the brokerage on the deal.

In the case of bonds, most deals are done through phones with brokers. Thus if SBI wishes to buy a Rs 100 face value bond, it will now have to pay Rs 100.15 (plus brokerage) as the purchaser of this bond. In the next chain of transaction, SBI would sell this at an average Rs 100.30 (including profit). Now, if say, Punjab National Bank wishes to purchase this bond, it would pay 0.15 per cent extra on Rs 100.30.

It is feared that the entire trading system will now shift to the negotiated dealing system, where the security transaction tax does not apply. The NDS, which is monitored by the RBI, has 80 per cent of its deals done through brokers, who report it to the exchange. The NDS is simply like a settlement system and analysts argue that if the trading system shifts entirely from phone-based to the NDS, it does not help price discovery.

Ashok Lahiri, chief economic adviser to the government, has said, "The proposed tax was aimed at curbing "very, very short-term speculative trades."

Turnover Tax: The International Experience

Our research shows that several developed countries have, in earlier decades, introduced the securities transaction tax on stocks/bonds but with mixed and nervous results. A recent research paper on impact of turnover tax done by Hiroyuki Ono, Faculty of Economics at Tokyo-based Toyo University, says, "The results from time series regressions and forecasting indicates that transaction costs do have a negative effect on the trading volumes and its degree has increased in recent years."

Countries like USA, France, Germany and Sweden have abolished the turnover tax in recent years while others like UK, Denmark and Korea have reduced the tax.

Transaction costs

So to say that the turnover tax is an internationally accepted practice is true but it has not been popular nor highly effective if the tax is too steep. The government will have to constantly weigh the options and alter the tax from time to time.