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Commodity transaction tax not a prudent idea

Feb 22 2013, 09:06 IST
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SummaryThe commodity transaction tax was proposed in Union Budget 2008-09 and withdrawn in July 2009-10, following the recommendations of the Prime Minister’s Economic Advisory Council.

The commodity transaction tax (CTT) was proposed in Union Budget 2008-09 and withdrawn in July 2009-10, following the recommendations of the Prime Minister’s Economic Advisory Council. In the wake of a raging debate in the media and demands from certain groups on imposing transaction taxes on commodity derivatives, it seems pertinent to revisit the importance of commodity derivatives markets and impact of CTT on them.

Pure economic logic reveals that the potential benefits of CTT will definitely be outweighed by the costs of its levy. Axiomatically, commodity exchanges are supposed to reduce transaction costs associated with finding buyers and sellers. Functionally, such institutions are supposed to promote efficiency in production, planning, storage and marketing through price discovery and hedging functions. Both price discovery and hedging functions are contingent upon volumes and liquidity.

If the idea of a CTT has been conceived to generate revenues, discourage speculative trading and reduce volatility, it needs to be unveiled that the idea is misplaced. This is because the efficiency of this hedging platform is an inverse function of the cost of transacting on it. It needs to be reiterated here that the objectives of garnering revenues and reducing speculation are contrary to each other. CTT, by increasing cost of transactions, will dent short-term transactions. With such ‘crowding out’ of short-term volumes, there can be losses in incomes and concomitant tax collections, which might even outweigh the expected revenues from CTT.

Again, such reduction in market liquidity will increase the bid-ask spread, a major component of transaction costs. This will increase the price volatility, with potentially cascading destabilising impacts on the physical markets. Again, by increasing the cost of participation, CTT will also shift trading volume either to the overseas markets or to the illegal markets, which are relatively low-cost destinations.

It is a double-whammy for hedgers as CTT will increase both the direct and indirect costs of hedging. While directly the cost-incidence will increase in proportion with amount of tax imposed, there will be an indirect cost, too.

This will be in the form of higher risk premiums to speculators, due to reduction in volume, increasing the aforementioned bid-ask spreads. As such, hedging instruments like commodity derivatives are extremely sensitive to costs of transactions. A study in China has revealed that an increase of 0.2 percentage points in stamp duty reduces the trading volume by a third. Similar evidences are available in other hedging markets like forex and interest

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