The tax with potential side effects

This report is from this week’s CNBC’s “Inside India” newsletter, which brings you timely, insightful news and market commentary on the emerging powerhouse and the big businesses behind its meteoric rise. Like what you see? You can subscribe here.

In 1696, King William III of England introduced a radically new tax on his subjects to raise state revenues: under the decree, every household in the country would pay a levy depending on the number of windows in their home. This typically meant that the larger the house, the greater the tax due on it.

Despite its progressive intentions, the tax failed to raise sufficient revenue for the monarch, as people boarded up their windows to lower their tax liability. Over the long term, the policy was a net negative for the state, which had to battle typhus, smallpox and cholera epidemics resulting from the lack of ventilation.

So, what does the window tax have to do with India today?

Earlier this week, India’s finance minister surprised markets with a measure she said will “deepen the tax base.”

Nirmala Sitharaman, delivering her seventh Budget, raised the tax on trading futures and options to 0.02% and 0.1%, respectively — marking a 60% hike. In addition, the minister also lifted capital gains for stock market investors who cash in within a year from 15% to 20%. Long-term investors will also pay a revised rate of 12.5% on gains, up from 10%.

For now, the tax hikes appear to have overshadowed many positive developments arising from the Budget. Foreign investors have liquidated nearly $1 billion worth of Indian equities in the two days since the Budget was announced and traders have sent stocks lower every day so far since then.

“The lack of populist spending is in line with our expectation, although the increase in capital gains tax for equities is against our expectation of no change,” said Upasana Chachra, chief India economist at Morgan Stanley, in a note released to clients immediately after the Budget was unveiled.

Will the government achieve its goal through the levy, even if investors look past the initial pain?

“This rise in short-term capital gains tax from 15% to 20% will thus discourage excess trading activities, while the hike in long-term capital gain taxes from 10% to 12.5% is sentimentally negative for the market in the near term,” said Siddhartha Khemka, head of retail research at broker Motilal Oswal.

Not everyone is convinced.

“It may help to defuse some of the more speculative nature of the market but is unlikely to deter retail investors in a significant way,” said Michael Langham, emerging markets economist at U.K.-headquartered asset manager Abrdn. “This move can be seen as part of the broader effort by regulators to curb some of the financial stability risks building in the equity markets, and it’s not far-fetched to imagine further measures to taper some of the retail investor risks.”

In fact, the risk for regulators could actually be inspired by modern Britain.

The U.K. introduced a stamp duty tax on each transaction in 1974. While the tax raises more than £3 billion ($3.9 billion) annually, it has given birth to far riskier forms of speculation while simultaneously hurting the stock market.

Spread betting and contracts-for-difference (CFD), which exposes traders to far higher levels of potential losses — as well as gains — have boomed since the 1990s. As neither product results in stock ownership, the trading tax is entirely avoided.

The tax also plays a role in suppressing valuation levels for the U.K.’s very profitable companies, according to the Institute for Fiscal Studies.

However, given the lofty valuations that Indian stock markets currently trade, the tax to skim the excesses might be a positive development over the longer term.

India is likely to ease curbs on some Chinese investments. Restrictions are likely to be lowered on investments in non-sensitive sectors like solar panels and battery manufacturing, where India lacks expertise, according to the Reuters news agency. The plans mark the first step in improving economic ties between the two neighbors, a relationship that worsened after clashes in the remote Himalayan border in 2020.

Indian stocks have declined for five consecutive days. The Nifty 50 index has fallen by 0.65% so far this week, though the benchmark is up 12.1% this year.