Budget

Frying The Fish and Feeding The Sharks

Sanjeev

Sanjeev

There is a lot of talk in the markets about the recent Budget provisions on Capital Gains and Turnover Tax. I think I have something to say, which I have not seen in the recent articles on the Budget.

Declaimer: This article was originally in July 2004 and some of the data points may be outdated.

The economic establishment in this country is dominated by ‘classical economists’ who deal with static models of taxation, ie, models that do not anticipate human behavior, but take it as unchanging and constant. This is a flawed view.

Sometimes, the observer does something that changes the behavior of what he is observing. That is when you have “shot from a cock-eyed gun”, and the bullet comes back to shoot you in the foot. The Govt of India is a past master at this fine art (of shooting itself in the foot). It often ignores the role of its tax policy, in the generation of the taxable income itself.

Let us now look at this new set of provisions on the Capital Markets.

Markets are made up of many kinds of participants, and many kinds of independent behavior. Without going too deep into the details, I will point to 3 kinds  of participants and their behavior:

  1. Retail: this poor fool gets taken to the cleaners every few months. He is the day trader, or at best, the short-term trader, with concise views on the market.

Since he never earns any money anyway, he is never taxable. He is the fellow who loses all the money that ends up in the hands of the intelligent few, as taxable income. When the Govt was charging Short–term and Long- long-term capital Gains, those big, intelligent ‘sharks’ of the sea were the ones who were paying up.

  1. Institutions: these are the big, lumbering ‘whales’ of the market (some of them are ‘sharks’, but mostly, they are vegetarian and too busy trying to ‘beat the market’ to do any significant damage to the small investor)
  2. Smart Guys: these are the intelligent kings of the jungle. They are Nature’s way of ensuring that there is not too much stupidity in the markets. They are the snakes who ensure that there are not too many rats around.

These are the fellows who sell at the big spikes you see in most technical charts. They are big because they have grown fat on all those poor fish who have been getting cleaned out over the years. They have fangs, because they have a deep understanding of the market, of the real value of the stock, and of human irrationality…………..they hunt in packs and can break the back of any rally in the market.

They are sure of themselves, they have the media under their control, and they can turn public sentiment at the switch of a cellphone button.

Now let us examine what Tax Policy does to each segment of market behavior. For all the hoo-hah about the Turnover Tax, it hurts only the day trader and his turnover. That hurts the stock brokers, a powerful lobby group, which is why the media is full of stuff about them. Frankly, I would ignore this issue, because it does not affect price discovery in any significant way.

Long Term Capital Gains should have gone a long time back. It is a good policy because it rewards the real investor, who seeks to get his gains from business transformation. Although these are often the rich, they should still be rewarded, because tax policy seeks to reward Savings behavior, and returns from Savings should be looked upon kindly if you want to promote Savings and Capital Formation.

Most of these big, intelligent investors (the Warren Buffets of India) stay out of the short-term markets partly because of tax policy (35% Short-Term Capital Gains Tax Vs. 10% Long-Term Capital Gains Tax). According to research, this kind of behaviour makes ~65% of the profits made on the stock market, even though it accounts for just ~1% of the trades. These sharks do not come out very often, and that is good for the market because it helps to build up ‘sentiment’ (which is nothing but the poor fish congregating in shoals so that they are easier to catch).

So the Turnover Tax does not catch such people, but the Long Term Capital Gains Tax does.  This is where the real profits of the market are, but the Govt has chosen to tax the poor and exempt the rich.

The most retrograde provision is the drop in Short-Term Capital Gains Tax. This will bring out the sharks more often, because of another peculiar economic phenomenon called the Fallacy of Composition. In very short, this is a complicated way of saying that “what is good for the goose is not good for the geese”. I will explain…..!

Most of those sharks did not come out to hunt, because the Govt was taking 35% of their prey if they came out before a year. That was allowing the fish to multiply, giving the market some direction, and allowing sentiment to build up.

There is a term in financial markets…” profit potential” of a market. In simple terms, it refers to the fish who have congregated in a shoal (and refers to the amount of prey in the sea). A shark only wants to feed off the prey available, he does not increase his size beyond that.

The only thing the shark fears is another shark. Now, with just a 10% tax rate on Capital Gains, he fears another shark will come out and take his prey away, ie, he will ‘farm’ the poor fish early in the rally.

So while he is happy that the Govt has dropped the tax rate, he now worries that other sharks will come in and sell early in the rally, simply because ‘they have made enough money’. This is the Fallacy of Composition, where even as he celebrates the drop in his tax liability, he worries that his income itself will come down. So that will drive him to sell early.

Remember, this guy (shark) is good for the food chain. But now, with quick extinguishment of rallies, the market will turn more volatile as these guys will come to sell more often, and at shorter spikes. As the market turns volatile, Risk goes up (ah! Now the classical economists can understand….!), and with it, so does the Cost of Capital in the economy. Price discovery is hampered, and stocks will not reach full valuation, because long before that, the poor fool (retail investor) who is mostly responsible for the “linear thinking” that drives big, long rallies, will have given up and gone home.

If you want to verify what I am saying………..let someone in Govt do a Research Project. Take a list of the big taxpayers of last year under this head, and classify them under “Behavioural Heads” as above. Now take a list of taxpayers this year, and observe how their composition has changed. You will find the poor fools (Turnover Tax) are paying more tax, than the “sharks”. So the government has gone and taxed the poor and exempted the rich.

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