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Commodity transaction tax: A thorn in the flesh
June, 23rd 2009

There is a strong case for the government to remove the threat of commodity transaction tax (CTT) by deleting the relevant provision from the Finance Act 2008-09. The coming budget is the right opportunity for this. The proposed tax is untenable not only because it has the potential to drive commodity futures business overseas but also because the impost would not even serve its express purpose of reducing price volatility.

It must be noted that the top 25 commodity derivative exchanges in the world are not subject to CTT. Also, there is no transaction tax in the currency derivative market and on gold exchange traded funds. A transaction tax will certainly have an adverse bearing on Indias commodity exchanges that are struggling to grow. The tax would make the exchanges more expensive, forcing commodity businesses/ traders to dump them for cheaper exchanges abroad.

According to the Finance Act 2008-09, CTT would be levied at the rate of 0.017% of the value of transaction. One estimate is that this would increase the cost of transaction by almost 800%, thereby making Indias commodity futures exchanges the costliest in the world. If CTT is implemented, out of the total transaction tax, 85% will be towards CTT and the balance will be towards exchange fee, service tax, stamp duty, etc. So, the tax is not as small as it appears to be. After all, commodity futures is a volume-driven, extremely low-margin business. A 0.25% margin is something to aspire for in this business!

As the number of transactions increases, the futures market will turn more efficient in performing its principal function of providing the benefits of price discovery to different types of producers, especially farmers. More transactions would mean better management of price risks. A large number of arbitrage transactions would help in linking the futures and options prices to real prices. CTT-induced lower trading volume, on the other hand, could lead to higher volatility in prices, impairing the markets price-discovery function.

Immediately after the Budget 2008-09, there was a hue and cry over the proposed tax. The national-level exchanges National Multi Commodity Exchange, Multi Commodity Exchange of India and National Commodity and Derivative Exchange as well as the Forward Markets Commission, the regulator, pitched for withdrawal of the proposal. The prime ministers economic advisory council promptly examined the matter and reportedly recommended halving the tax. The government apparently buckled under the pressure of the contrarian popular view and therefore, the budget proposal has not yet been implemented. But the Finance Act 2008-09 very much has the provision for imposing CTT at any time the government wants it. This threat is unwarranted. It has had a psychological impact on Indian commodity bourses as well as those trading on them.

Unlike in the stock market, investment institutions, mutual funds and foreign institutional investors (FIIs) are not permitted to operate in the commodity futures market. Besides, options contracts, index futures and futures based on intangibles are also prohibited in the commodity futures market. So, it is difficult anyway for undesirable elements to distort the markets.

Whats needed at this juncture, therefore, is to allow futures markets to play a more meaningful role in helping Indias farmers to realise higher prices for their produce. Market participants, especially the farmers and co-operatives need to be encouraged to make additional investments in marketing infrastructure such as price dissemination networks, warehousing, storage facilities and testing laboratories. Robust commodity exchanges and a strong futures market are essential for creating the conditions conducive for such investments.

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