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%.

Borrowing a page from 17th century England, India’s finance ministry hopes to enact a behavioral change with the levy and stamp out the “unchecked explosion” in the derivatives market, where retail investors account for 41% of total trading volumes.

What may become a cause of government concern is if stock market traders attempt to lower their tax burden, instead of weaning away from what has effectively become gambling and from its unintended negative consequences.

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.

India “clearly has a problem,” says JPMorgan’s Jahangir Aziz. The chief emerging markets economist believes India needs to figure out new drivers for its economic growth even as it expands rapidly. “It is going to be very difficult for India to keep sustaining the 6% to 7% growth rate just on public infrastructure and on services export,” Aziz told CNBC.

Outbreak of the deadly virus. Health authorities in the southern Indian state of Kerala are on high alert following the latest flare-up of the deadly Nipah virus. It comes after a 14-year-old boy died from an infection over the weekend. First identified 25 years ago in Malaysia, Nipah is estimated to have a case fatality rate as high as 75% and has been cited as having the potential to spark another pandemic.

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.

The benchmark 10-year Indian government bond yield has ticked lower to 6.95%, after the Indian government lowered its forecast for this year’s deficit to 4.9% of GDP, from 5.1%.

On CNBC TV this week, Raghuram Rajan, former governor of the Reserve Bank of India, said the country needs to invest in education and skilling to attract investment in sectors that add more value.

“If you look at the budget, again, what you would worry about is the enormous amount of investment going into infrastructure and the much more limited investment going into human capital building,” he told CNBC.

Meanwhile, Suman Bery, vice chairperson at the Indian government’s public policy think tank Niti Aayog, said it would be “somewhat misplaced” to assume that the Budget unveiled this week was the consequence of the 2024 election results.

“India has been adding jobs, but they have been low-productivity jobs and the only way for India to accelerate its growth rate is to move its demographic dividend — its labor force — into higher productivity jobs, and that’s going to require various kinds of structural changes,” Bery said.

U.S. tariffs on several Chinese imports kick in next week. On the data front, several central banks are scheduled to release some key decisions.

July 26: U.S. core inflation

July 30: Japan unemployment rate, Eurozone GDP, Germany inflation

July 31: U.S. interest rate, Eurozone inflation

August 1: U.K. interest rate