Tax with potential side effects

This report is taken from CNBC’s Inside India newsletter this week, bringing you insightful market news and commentary on emerging powerhouses and the big companies behind their meteoric rise. Like what you see? Sign up here.

In 1696, King William III of England imposed a radical new tax on his subjects in order to raise state revenue: by decree, every household in the country had to pay a tax based on the number of windows in their house. This usually meant that the larger the house, the higher the tax it owed.

Despite its progressive intentions, the tax failed to raise enough revenue for the king, as people closed their windows to reduce their tax obligations. In the long run, the policy was completely negative for the state, which had to combat epidemics of typhus, smallpox, and cholera caused by lack of ventilation.

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

Earlier this week, India's finance minister surprised markets with a move she said would “deepen the tax base.”

In her seventh budget presentation, India’s Finance Minister Nirmala Sitharaman raised the tax on futures and options trading to 0.02% and 0.1% respectively — a 60% increase. In addition, the minister also raised the capital gains tax for stock market investors who profit from their investments 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 bring about behavioural change through the tax and eliminate the “uncontrolled explosion” in the derivatives market, where retail investors account for 41% of total trading volumes.

The government's concern may be that stock market traders will try to reduce their tax burden, rather than walk away from what has become gambling and its unintended negative consequences.

For now, the tax hikes appear to have overshadowed many of the positive developments from the budget. Foreign investors liquidated nearly $1 billion from Indian stocks in the two days after the budget was announced, and traders have been cutting shares every day since.

“The lack of populist spending is in line with our expectations, although the increase in the capital gains tax on stocks is inconsistent with our expectation of no change,” Upasana Chachra, chief economist at Morgan Stanley, said in a note to clients immediately after the budget was unveiled.

Will the government achieve its goal through the tax, even if investors ignore the initial pain?

“This hike in short-term capital gains tax from 15% to 20% would discourage excessive trading activities, while the hike in long-term capital gains tax from 10% to 12.5% ​​is emotionally negative for the market in the near term,” said Siddhartha Khemka, head of retail research at brokerage Motilal Oswal.

Not everyone is convinced.

“This may help to calm some of the speculative nature of the market, but it is unlikely to deter retail investors significantly,” said Michael Langham, emerging markets economist at UK-based asset manager Aberdeen. “This move can be seen as part of broader efforts by regulators to reduce some of the financial stability risks that are building up in equity markets, and it is not out of the question to imagine other measures being taken to reduce some of the retail investor risk.”

In fact, the threat to regulators may be inspired by modern Britain.

The UK introduced a stamp duty on every transaction in 1974. While the tax generates more than £3 billion ($3.9 billion) a year, it has led to riskier forms of speculation while also damaging the stock market.

Spread betting and CFDs, which expose traders to much higher levels of potential losses – as well as gains – have flourished since the 1990s. Since neither product leads to ownership of shares, trading taxes are avoided entirely.

The tax also plays a role in suppressing valuation levels for highly profitable companies in the UK, according to the Institute for Fiscal Studies.

However, given the high valuations at which Indian stock markets are currently trading, a tax to reduce surpluses could be a positive development in the longer term.

India is likely to ease restrictions on some Chinese investments. Restrictions are likely to be eased on investments in non-sensitive sectors such as solar panels and battery manufacturing, where India lacks expertise, according to Reuters. The plans represent a first step in improving economic ties between the neighbors, which soured after clashes on a remote Himalayan border in 2020.

“India clearly has a problem,” says Jahangir Aziz of JPMorgan Chase. The country’s chief emerging markets economist believes the country needs to find new drivers of economic growth even as it expands rapidly. “It will be very difficult for India to sustain growth of just 6% to 7% in public infrastructure and services exports,” Aziz told CNBC.

Deadly virus outbreak. Health authorities in the southern Indian state of Kerala have declared a state of high alert following an outbreak of the deadly Nipah virus. This comes after a 14-year-old boy died from the infection over the weekend. The Nipah virus was first identified 25 years ago in Malaysia, and has an estimated 75% mortality rate, and is said to have the potential to spark another pandemic.

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

The benchmark yield on India's 10-year government bonds fell to 6.95% after the government cut its deficit forecast for this year to 4.9% of gross domestic product, from 5.1%.

In an interview with CNBC this week, Raghuram Rajan, former governor of the Reserve Bank of India, said the country needs to invest in education and skills development to attract investment in sectors that add more value.

“If you look at the budget, again, what might concern you is the enormous amount of investment that goes into infrastructure and the very limited investment that goes into building human capital,” he told CNBC.

Meanwhile, Suman Beri, vice-president of the Indian government's public policy think tank NITI Aayog, said it would be “somewhat wrong” to assume that the budget unveiled this week was a result of the 2024 election results.

“India has added jobs, but they have been low-productivity jobs,” Perry said. “The only way for India to accelerate its growth rate is to move its demographic dividend — its workforce — into higher-productivity jobs, and that will require different kinds of structural changes.”

US tariffs on a range of Chinese imports will take effect next week. On the data front, several central banks are set to make some key decisions.

July 26: US Core Inflation

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

July 31: US interest rates, Eurozone inflation

August 1: UK interest rate