The changes in taxation of transactions in futures on equity and commodity underlyings

Taxation of transactions in India began with the equity market in 2004. Prior to 2008, the securities transaction tax (STT) was allowed as a rebate against tax liability against Section 88E of the Income Tax Act. This treatment was withdrawn by the 2008 Budget announcement. After that, STT became a substantial influence on the equity market. In understanding the consequences of the STT, there is an absolute perspective and there is a relative perspective.

In absolute terms, suppose you embark on a spot-futures arbitrage and do an early unwind. In this, you buy shares (pay 10), sell futures (1.7) and then reverse yourself (10). Your tax burden is 21.7 basis points. This is a lot of money when compared with the typical bid-offer spread of the Nifty futures which is around 0.5 basis points. The dominant cost faced in doing spot-futures arbitrage is taxation.

In relative terms, there are two issues. The first is an intra-India comparison between equities and commodities. When activity on the equity market was taxed, eyeballs and capital moved to commodities trading. Commodity futures trading has grown by 3.5 times after 2008, while equities activity has stagnated. Most policy makers think this was an undesirable effect, particularly given the fact that India can free ride on global price discovery for non-agricultural commodities but must foster liquid markets in its own equities.

And then, there is an international dimension. When the activities of non-residents in India are taxed in any fashion, they favour taking their custom to places like Singapore, which practice `residence-based taxation' where the tax base comprises the activities of residents only. We got a sharp shift in equities activity towards locations outside India.

Putting these absolute and relative perspectives together, from 2008 onwards, equity market liquidity has fared badly. This yields an elevated cost of equity capital.

The budget speech has done two things. First, it has dropped the STT rate on futures on equity underlyings from 1.7 basis points to 1 basis points. This is helpful for certain kinds of trading strategies but not for others (e.g. the spot-futures arbitrage described above will gain little). HF strategies that do not involve the spot market will particularly benefit - e.g. imagine an options market maker who does delta neutral hedging on the futures market. Second, it has introduced taxation for non-agricultural commodity futures on an identical basis to the equity futures (i.e. at 1 basis points).

This will have the following interesting implications:

1. Capital and labour in securities firms will be less inclined to be in non-agricultural commodity futures. It will tend to move towards agricultural commodity futures, currency futures and equity futures.
2. The comparison between offshore venues and the onshore market will move in favour of the onshore market for certain kinds of trading strategies.
3. The bias in favour of equity options will reduce; some business will move to equity futures.
4. The pricing efficiency of futures will go up.

In this environment, there seems to be a fair arrangement between the equity futures and commodity futures. Conditions seem to be unfair with the equity spot (too high), equity options (too low) and currency derivatives (too low). The next moves on this may appear in July 2014 when the new government unveils its next budget.

One more announcement of the budget speech concerns currency futures: it was stated that FII activity on currency futures will commence. This will also give more activity on currency futures; we now have two reasons for expecting more activity on currency futures (the taxation of commodity futures and the entry of FII order flow). However, the shifting of FII order flow will be a slow process, and a lot of time will be lost on their due diligence of the exchange, safety of the clearinghouse, and so on. While, in the long run, removing capital controls against FII order flow in India is a good thing, it is not an effect that will kick in quickly. Apart from this, most of the action will take place fairly quickly, in early April.

Future finance ministers will need to navigate the difficult landscape of gradually scaling down taxation of transactions while retaining low taxation of capital gains (which has unfortunately come to be seen as a linked issue in the Indian discourse). Along this path, the first priority should be to remove distortions. Our first priority should be to achieve a low rate, a wide base, and the minimal distortions. Reduced rates will always yield welfare gains. The Budget 2013 announcement makes progress on two things (reduction from 1.7 to 1, and reduced distortions between equities and non-agricultural commodities). There is much more waiting to be done: integrating currencies and fixed income, bringing sense to options, and getting away from the very high rates on the equity spot market.

Interesting readings

The liberal DNA by Pratap Bhanu Mehta in the Indian Express.

Kanika Datta in the Business Standard on how Narendra Modi is becoming more accepted.

Ashoka Mody and Michael Walton interpret India's new willingness to accept high and unstable inflation.

In continuation of my posts Activism and wonkery are the yin and yang and Law and order: How to go from outrage to action, see The power of populists and naysayers by N. C. Saxena in the Indian Express.

Spreadsheets considered harmful.

Bank for the buck by Ila Patnaik in the Indian Express.

Nandini Raghavendra in the Economic Times about the global success of Indian television shows. Also see Alessandra Stanley in the New York Times.

A finer balance by Ila Patnaik in the Indian Express.

Nidhi Nath Srinivas in the Economic Times on the Commodities Transaction Tax.

All states in India, other than West Bengal, Tripura and Kerala, had shifted their civil servants into the New Pension System. Now Kerala has moved! Oommen Chandy, the Chief Minister of Kerala, has been evangelising this.

Quick fix failures by Pratap Bhanu Mehta in the Indian Express.

An editorial in the Indian Express on proposals to tax the rich.

Rajesh Abraham and Manju AB in the Financial Chronicle on the rise of rupee trading overseas.

In an interview in the Business Standard, Percy Mistry worries about the entry of business families in banking. We have seen the fit-and-proper process go wrong with stock exchanges, and must worry that strange characters will now become banks.

Emre Deliveli writes an interesting blog on Turkish economics as part of Roubini Global Economics. He has a post where he gets struck by a phrase by the Turkish central bank governor: `short-term capital flows could disrupt price and financial stability by causing excess volatility in lending and exchange rates'. As with a lot of what India's RBI says, it sounds like plausible mumbo jumbo and passes muster in the conventional low quality economic discourse, but actually betrays a lack of knowledge of monetary economics.

It has been an impressive set of weeks in the recent past for the intellectual life in Delhi.

William Gerrity on Slate on the experience of being attacked by Chinese hackers.

Sweden is often held up as the model of the welfare state. What is not widely known is that they are turning away from this. Read Adrian Woolridge in the Economist says The streets of Stockholm are awash with the blood of sacred cows. The think-tanks are brimful of new ideas.

John McAfee has an amazing post about how he penetrated the security of the government of Belize - and found mind-blowing secrets. Both elements -- how he broke in, and what he found out -- are worth pondering.

The US White House responds to a petition to Secure resources and funding, and begin construction of a Death Star by 2016. The cost has been estimated at 2012 US GDP for 56666 years. But all is not lost. A mere 500 years at 3% GDP growth will turn this estimated cost of building Death Star into 2.16% of projected US GDP. The trouble is, there may be basic constraints to the notion of 3% GDP growth for 500 years.

I decided not to watch Zero dark thirty.

We knew that T. gondii hacks you to change your risk aversion. Now we find that the flu hacks you to make you more social.

I knew of a driver at MoF who sub-contracted the work of driving to someone else and kept the difference between the government wage and the market wage. Here's a similar labour arbitrage.

Nicholas Carr reminds us that to experience life is to break the shackles of the self.

A great note by Timothy Burke on the notion of investing in social network companies, and why facebook has this great proclivity to go bad on you.

Like Arduino, the Raspberry Pi seems to be working great. Pete Lomas has a great story in Wired magazine about the tradeoffs which went into it. Available in India for Rs. 3500. Can these trigger off a next revolution in knowledge?

In continuation of the ipad 2 having more power than the Cray 2, the computational capabilities of Curiosity are worse than a typical smartphone today.

Adam Gopnik has a beautiful article about Galileo's world, in New Yorker magazine, that makes us think about our own.

How to improve freedom of speech in India

Most of us in India understand that there is a huge problem with freedom of speech in India. India now ranks at the bottom of the world on freedom of speech. Here is some interesting discussion on such facts.

For a sense of the zeitgeist, see an editorial and Lawrence Liang in the Economic Times. R. Jagannathan on FirstPost reminds us that judges in India are not intellectuals who will lead the way on this.

Public shaming

There are two ways through which things are getting better. The first area of importance is public outrage. Even if India has laws that hinder free speech, we should all speak up and establish social norms in favour of free speech, where the use of existing laws that support attacks on freedom of speech is just not done.

As an example, Vodafone embarked on legal bullying against one person, but backed away when faced with outrage.

A splendid example of this push back is IIPM. Recent events (link, link) should make IIPM regret having gone down this route. Speaking for me, I have not accepted and will not accept invitations from IIPM for speaking or writing in their publications, and I will be quite circumspect about resumes that carry the name IIPM. (This is my standard operating procedure for left tail organisations in India). If enough of us do this, it will establish deterrence.

Outrage matters. We should be naming and shaming the offenders and maintaining a hall of shame.

Fixing the laws

The real problem is the laws. Modifications are required -- large and small. We need to shift away from proscribing defamation, obscenity, blasphemy to a stance of supporting freedom of expression. Restrictions on freedom implemented through government control on the Internet need to give way to accepting freedom of the Internet. What is new in recent months is that the outrage has bubbled up to the point where many people are saying Let's go fix the laws:

• An excellent television conversation between Shashi Tharoor and Karan Thapar.
• Pratap Bhanu Mehta in the Indian Express talks about the unusual response of Omar Abdullah and a delicious quotation from Manish Tewari.
• Suketu Mehta in the New York Times says that we must fix the Constitution.
• Jay Panda, Lok Sabha MP, has begun working on private members bills that will fix the laws.

Small modifications of the laws will constitute elements such as: shifting defamation from criminal to civil liability, and having a provision where costs are always paid to the defendant if the accusation does not hold. Fundamental change will constitute fixing the Constitution.

Conclusion

Capitalism and freedom reinforce each other. Both require the ability to think (freedom of speech, freedom of thought) and the ability to act (to vote, to transact, to conduct business, to live). Achieving freedom requires pushing on both fronts -- on establishing a vibrant and open `marketplace for ideas' and on establishing freedom to act.

IIPM reminds us that apart from being a question of high ideas, this is a question of simple consumer protection. When a person thinks of getting a degree, he should have full information about the choices, and IIPM is trying to block that information. Similarly, consumer protection requires that for any publicly visible financial product or service, there should be an unrestricted marketplace of ideas, otherwise the ability of consumers to make wise choices is impaired.

In the best of times, liberal democracies suffer from too little criticism. If we are to make progress on dealing with the problems of corruption and runaway governments, the most important channel is high quality, pointed, trenchant criticism. The present laws are grossly out of touch with the principle of freedom of speech. We need to go fix that: first as a matter of social custom, and then as a matter of law. It appears that there is some movement on both fronts.