Will LTCG+STT hollow out India’s equity markets?

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The timing of the Indian government’s decision to reintroduce long-term capital gains (LTCG) tax is intriguing. Just last month, Singapore Exchange Ltd (SGX) told investors it had garnered a 52% share of global Nifty futures volumes, up from 47% a year ago. And combined with Dubai Gold and Commodities Exchange (DGCX), offshore centres have nearly caught up with Indian exchanges in dollar-rupee trading.

Encouraged by the success, SGX has launched futures contracts on 50 leading Indian stocks since 5 February. A big factor that works in its favour is Singapore’s taxation policy, which exempts capital gains tax and doesn’t impose a securities transaction tax (STT). In contrast, India now has the rare distinction of imposing both forms of taxation.

While offshore centres have become increasingly attractive to trade Indian assets, the irony is that they haven’t done anything spectacular to attract order flow. Thanks to a number of policy missteps, India has been gifting its financial market to centres such as SGX one product at a time. Last year, a flawed policy on the use of participatory notes drove away overseas participants to offshore centres. This year’s contribution is flawed tax policy.

Arvind Virmani, a former chief economic advisor in the finance ministry says, “Without tax economists who can analyse the effect of different taxes on incentives, efficiency and equity, we are doomed to stumble from one tax mistake to another.” The government hasn’t employed tax economistsfor years now, which is leading to mistakes in other areas as well.

J.R. Varma, a professor of finance at IIM Ahmedabad, says, “Over the last decade or more, tax policy has become primarily focused on revenue generation with too little attention to either fairness or economic efficiency.”

The government’s stance that exempting LTCG on equities is inequitable, especially when all other asset classes are taxed, is just one part of the picture—the revenue generation part. It brushes aside the double taxation argument against LTCG, for one. Urjit Patel, governor of Reserve Bank of India, even says that equity capital is taxed as many as five times in India, and that this can have an impact on investment decisions. Patel, incidentally, was part of the Vijay Kelkar task force on direct taxes that had recommended abolishing LTCG to avoid double taxation .

The fact that it works against the interests of India’s financial markets is another important aspect to consider. “STT is a tax on transactions and disincentivises transactions. Transactions will move to other jurisdictions if this is possible and if the cost of doing so is less than the cost of STT. This is perfectly predictable. The 10% LTCG will increase the incentive to shift trading to other jurisdictions,” points out Virmani.

Does this mean the government is oblivious of the international implications of changes in taxation policy or is it just giving the threat from offshore centres a nonchalant shrug? Not quite. It has a plan B to bring back volumes from offshore centres.

While trading in the mainland exchanges has become more taxing, the government has brought exchanges situated in international financial services centres (IFSCs) on par with offshore centres. Traders in these exchanges were already exempt from STT and LTCG; in last week’s budget, the finance minister also waived short-term capital gains taxes.

From the looks and sound of it, NSE and BSE will primarily rely on their exchanges running out of the IFSC in Gift City to win back volumes from offshore centres. “Gift City has the solutions to some of the problems that drove volumes offshore,” says an exchange official. This is bizarre, to say the least. It’s worse than sending your B team to the World Cup. “Gandhinagar is not seen as a financial centre; and people want to work in a financial centre where all linkages such as law firms etc. are in place,” says the head of one of India’s largest trading firms.

He adds that just as the IFSC in Dubai is an extension of the existing marketplace in the city, an IFSC that worked as an extension of the markets in Mumbai would have been far more viable.

In any case, relying on plan B or team B is flawed thinking, because this effectively means that India’s main markets will continue to get hollowed out. Whether traders use SGX or an exchange in Gift City, the fact remains that exchanges in the mainland will be hurt. Of course, since most domestic retail investors don’t have access to either offshore centres or IFSCs, existing markets won’t be completely hollowed out. And as they did with STT, some trading firms will build the additional cost into their models and move on. But liquidity can weaken over time, which will hurt price discovery.

One big worry with a policy stance that promotes IFSCs is that there will be no urgency to fix the gaps in the mainstay markets. Another concern related to their promotion is what the next course of action could be if tax incentives don’t do the trick. If, for instance, regulatory oversight is not maintained at stringent levels, with a view to attract order flow, it will be a huge disaster in the making. As argued in this column earlier, a far more practical alternative is to strengthen India’s existing markets. The fact that the government seems to be doing the opposite shows that it’s time to heed Virmani’s call and bring back tax economists into the policy making process.livemint