COMMENTARYEconomic & Political Weekly EPW september 27, 200817The best system is one where the gov-ernment – the State – takes up the respon-sibility for providing healthcare to its citizens, because this is not a short-term consumption expenditure, but a long-term investment in its people and their capacity to be productive citizens. Canada, Britain, Sweden, and many others have estab-lished such systems. They are financed by taxes, and are citizen entitlements. This is not to say there are no problems in these countries. There are different models at work in different countries. India should design its own, based on the best experi-ence in the world.That the State has failed spectacularly in providing healthcare, and opened the way for a private industry, does it mean that the state can never improve? Does it mean that we accept corruption and sloth as an unchanging given in our society? Does it mean that workable solutions do not – cannot – exist or that the State will always fail in service provision? The State in India has had many spectacular suc-cesses – when it sets its mind on a subject. We can – and must – move beyond this second-best solution in a sub-optimal world.The debate should be about the kind of state health system that India should have. It should be about the design of such a sys-tem. It should be about proper incentives and institutional structures. It should balance out medical needs, technical require-ments, costs, and huge distances – and many more issues that are India-specific. For example, we have an agricultural policy that subsidises sugar – the consumption of which is not considered conducive to good health – or rice, but not cereals like jowar and bajra which are part of the traditional diet and much better for health. Could not agricultural policy be made consistent with good diet that is an important part of any health policy? To encourage good health habits we need to look beyond hospitals, though they are essential.That the State must do all this is easy to say. Designing the system is the challenge. It is unfortunate we are taking the easy way out with private provision through insur-ance as against the better one of universal state coverage based on taxes. Failures of the past do not imply a failure to improve in the future, especially when there are exam-ples of state successes. Is this challenge beyond us as a people and a country?The views expressed here are personal.Madhoo Pavaskar (madhoopavaskar@yahoo.com) and Nilanjan Ghosh (nilanjan.ghosh@gmail.com) are with Takshashila Academia of Economic Research, Mumbai.Commodity Transaction Tax: A Recipe for DisasterMadhoo Pavaskar, Nilanjan GhoshThe commodity transaction tax announced in the 2008 Union Budget will prove counterproductive for it will provide little revenue for the government and at the same time, unsettle the commodity derivative market.Economic utility of no economic activity is so little understood and so much misconceived as that of commodity derivative trading. Had it not been so, the Union Budget for 2008-09 would not have clamped a devastating transaction tax of 0.017 per cent on the sale of a commodity derivative contract. Such unprecedented commodity trans-action tax (CTT) betrays utter lack of understanding on the part of the authori-ties that a commodity futures market is essentially a hedging market, unlike a securities market that serves primarily the financial investors, either retail or institutional, besides hordes of specula-tors. In contrast, a commodity derivative market performs a vital economic func-tion of assisting the physical market func-tionaries in price discovery (by providing proper benchmark or reference prices so as to enable them to enter into physical contracts for forward delivery in the domestic and export markets at prices that truly represent the current expecta-tions of the present and prospective supply and demand conditions), while offering alongside an effective and effi-cient price risk management instrument. Not a Stock ExchangeAs it is, the rationale for the CTT is hard to comprehend. Nowhere have the authori-ties spelled out the reasons for such a levy, except that they had imposed a similar tax in the last financial year on securities mar-ket transactions. But a commodity exchange is clearly not a stock exchange. The economic objectives and intents of the two markets are altogether different. While the stock market players are inter-ested solely in making profits from the ex-pected rising stock values, the commodity market functionaries trade in commodity futures primarily to hedge their price risks in both the falling and the rising markets, depending on their commitments in the physical markets. While farmers, mer-chants, stockists and importers hedge their stocks and forward purchases against a possible price fall, processors, manufacturers, exporters and even trad-ers with forward sale commitments require hedging against probable adverse price increase. Hedging merely reduces their unforeseen losses in the physical markets and does not yield positive profits [Pavaskar 2004].It is therefore manifestly unfair to burden such genuine commodity market operators with a transaction tax. Price discovery by a futures market also has a much more basic role in a 
COMMENTARYseptember 27, 2008 EPW Economic & Political Weekly18commodity market than in the securities market. Unlike the spot price of a specified security, there is no single unique cash price quotation for a commodity that is valid throughout the country at any given time. In view of the unavoidable varia-tions in commodity prices over varieties, space and time, commodity market func-tionaries face much larger price risks than those holding or acquiring securities. Fur-thermore, besides merchants, even proc-essors and manufacturers as well as importers and exporters are required to enter into forward purchases and sales in commodities to ensure receipts and ship-ments of regular supplies at various places throughout the length and breadth of the country, and over time. Hence, the need for an active commodity futures market for an efficient price discovery that helps provide proper reference prices for physi-cal market transactions in forward con-tracts. Such a price discovery emerges from an active and liquid futures market that provides a forum for trading not only to the physical market functionaries, but also to all others who have the requisite market intelligence and information. But it may lack the necessary wherewithal and resources to hold physical commodities. This latter class, commonly described as speculators of diverse breeds, performs a vital economic service of risk bearing and assists in better price discovery. To tax them for performing such a service is patently iniquitous.Built-in Stabilising InfluenceSurprising as it may seem, a commodity futures market has a built-in mechanism for stabilising physical market spot prices that are prone to fluctuate in response to unpredictable shifts in marketable sup-plies. When supplies are plentiful, the futures price invariably commands a pre-mium over the spot price by an amount that approximates to the carrying (stor-age) cost. This kind of spot-futures price relation enables merchants to earn stor-age costs by hedging their stocks in the futures market, and hence, encourages them to accumulate surplus marketable supplies, thereby avoiding a slump in the physical market. That also ensures more equitable distribution of supplies over time, without depressing prices. On the other hand, when supplies are scarce, the futures price is always at a discount. It falls below the spot price because the pos-session utility of the commodity at such times increases so much as to inverse the normal carrying costs. Such inverse spot-futures price relation, in turn, discourages inventory demand and encourages mer-chants and manufacturers, instead, to hold at least a part of their inventory (not needed immediately) through cheaper anticipatory hedge purchases in the futures market rather than in the physical form, shunning in the process the inci-dence of storage costs. Insofar as such hedge purchases transfer, albeit partially, the immediate effective demand from the physical market to the futures market, these necessarily tend to arrest the rising trend in spot prices. Speculation is thus not the villain of the piece in the organised futures market as is often believed. It is not even the necessary evil as some may probably feel. It is essen-tially a vital antidote to the imperfect competition which otherwise character-ises most commodity markets. The gain from competition is an increasing function of the number of market participants and their turnover. Therefore, to foster compe-tition in the commodity derivative mar-kets, speculation should be encouraged rather than curbed [Pavaskar 1980].Impact of CTTAs it is, the decision to hedge in a futures market depends not only on the extent of price risk and the degree of its probability (which determines the possible gains from hedging), but, more importantly, on its cost effectiveness, too. No doubt, hedging reduces risks, but it is not altogether risk free. To be useful and efficient, it therefore needs to be adequately cost effective, too. The transaction cost is therefore the prime determinant of hedging choice. The high entry and exit loads will necessarily deter hedgers from entering the futures market. What is true of hedgers is equally true for speculators, especially day traders and small speculators like scalpers and job-bers. They often trade on as thin margins as almost a small fraction of just 1 per cent. Obviously, high transaction costs will sim-ply drive them out of the market. They will then prefer illegal market channels like bucket shops and ‘dabbas’. In point of fact, the national commodity exchanges have successfully weaned most of them from such illicit markets over the past few years. With the application of CTT, how-ever, illegal trading will once again flour-ish to the detriment of the economy. And the recognised commodity exchanges will be bereft of liquidity volumes, with hedg-ers and speculators deserting them in droves. As a consequence, for want of effective risk management and price dis-covery, marketing margins in the physical markets will swell up, raising further the prices charged to the consumers, while depressing simultaneously the prices paid to the primary producers. Incidentally, it should be recognised that in the long run, futures market opera-tions represent a zero-sum game for both hedgers and speculators as a class. Gains in one period are offset by losses in the other, while profits to some are counter-balanced by losses to others. Evidently, taxing commodity derivative transactions violate the elementary canons of taxation as defined by Adam Smith, ie, equity or ability to pay. And insofar as it destroys market liquidity, it does not meet the criterion of efficiency, too. The remaining two economic principles of taxation, namely, convenience and certainty, are also largely lost sight of. By rendering both hedging and speculation non-cost effec-tive, it is scarcely convenient for com-modity traders to pay tax on derivatives. Likewise, inasmuch as the tax is on the sale price of a derivative – which is far from static, being market determined – uncertainty unavoidably looms large overthe precise incidence of tax at any time. Worse still, CTT is not so much a tax on income – which otherwise, too, would be normally taxable, if and when earned – as a tax on efforts of market at price discovery and risk management. Clearly, taxing such efforts makes little economic Table 1: Estimated Total Income Tax Revenue from the Three National Commodity Exchanges for the Financial Year 2007-08: The Base Case (in Rs crore)Tax from brokerage income 196.35Tax from exchange income on transaction fees 13.09Tax from profits of intra-day traders 1,570.79Tax from profits of long-term players 654.50Total tax revenue 2,434.72NB:Figures have been rounded off to the second place of decimal.o ϕij = (1 − i j )*100 v
ij
COMMENTARYseptember 27, 2008 EPW Economic & Political Weekly20per cent from both the buyer and the seller of each transaction. Their income from such transaction fee will therefore be 0.004 per cent of the total value of all transaction. The net taxable incomes of commodity exchanges from such transac-tion fees will be liable to income tax at the rate of 30 per cent on an average. Such net taxable incomes may also safely be assumed to be 25 per cent of the gross transaction fees.Based on the foregoing assumptions, it appears that the aggregate income tax revenue from the commodity derivative trading at the three national exchanges during the financial year 2007-08, when their total turnover was valued at Rs 39.27 lakh crore, would have been as shown in Table 1 (p 18). Even assuming some overestimation in tax revenues from different sources, it seems reasonable to believe that the gov-ernment earned total tax revenue from derivative trading at the three national commodity exchanges of the order of not less than Rs 2,000 crore. The situation will surely turn for the worse with the enforcement ofCTT. The government pro-poses to impose aCTT of 0.017 per cent on the turnover, and if the turnover in 2007-08 is the benchmark, the govern-ment will be expecting to raise tax reve-nues of Rs 667.59 crore from the three national level exchanges.Alternative Revenue ScenarioAs stated earlier, the imposition of CTT will drive away most intra-day derivative market players – trading on slender mar-gins – reducing thereby the intra-day trad-ing volumes. With the resulting reduced liquidity and the consequent rise in the cost of trading, many hedgers and long-term speculators would also prefer to stay away from the market. It may be reasona-ble to assume that the volumes of such hedgers and long-term players will fall in the same proportion as those of the intra-day traders. On this assumption, Table 2 (p 19) presents alternative scenarios of estimated revenues to the government from all sources on account of commodity deriva-tive trading. These estimates are based on the expected reduction in the trading volumes from the base year 2007-08 by different proportions, as a result of the application of CTT. As may be seen from this table, even as low as 20 per cent fall in the trading vol-ume after the imposition of the CTT, the net addition to the total government reve-nues will be just Rs 47.12 crore. Once the trading volumes starts declining by 25 per cent and more, far from adding any revenue to the central exchequer, the government will begin to lose more revenues than what it fetches from CTT. In fact, the net revenue loss to the govern-ment, owing to the application of CTT will exceed Rs800 crore when the derivative trading turnover slips to 50 per cent of last year’s level. ConclusionsMarket functionaries actually anticipate a fall in trading volume by as much as 65-75 per cent. There are also apprehensions of as high as 90 per cent reduction in such volumes after the enforcement of CTT. These expectations suggest thatCTT will result in a net revenue loss ranging from Rs 1,350 crore to over Rs 2,000 crore. Actually, the net revenue loss to the government will be much higher, if one were to consider the indirect and induced effect of loss in futures trading activity. Such loss will result in closure of business by most trading and broking houses, lead-ing to widespread unemployment and fall in incomes all round. With such a multi-plier effect, it may not be surprising if the net loss in the revenues to the government exceeds Rs 5,000 crore. In short, not only CTT forebodes the early demise of commodity derivative trading in the coun-try, to the detriment of the market func-tionaries in the physical markets who will be deprived of the benefits of price dis-covery and risk management, but will also be counterproductive to the govern-ment in earning any revenue. To be sure, CTT is a recipe for disaster not only to commodity markets, but even to the government as well. ReferencesMadhoo Pavaskar (1980): ‘Speculation and Futures Trading’,The Economic Times, Mumbai, February 14 and 15.– (2004): ‘Commodity Exchanges Are Not Stock Exchanges’, Economic & Political Weekly, Vol XXXIX, No 48, November 27-December 3, pp 5082-85.
