Noble it may sound, rotten it smells. The FM's venture to incorporate Transaction tax on securities, though high-minded lacks historical perspective. Such a tax has been abolished in many countries after its adverse impact on the markets. The trading volumes go down. Cost of capital becomes higher for companies. Markets become vulnerable to easy manipulation. The expected payoffs - "reduced volatility" and "large revenues" are not realized.

The trading volumes will go down significantly because of lower frequency of intra day trading and reluctance of FIIs to churn their portfolios. Investors and Companies start exploring other exchanges and means. High transaction costs may induce black markets' trading. When the equity tax was doubled in Sweden in 1986, a half of all Swedish equity trading moved to London. UK and Japan suffered similar fate during such tax regimes.

The above is well captured in the long-term price elasticity of trading, which varies from -0.15 to -1.35. The bid ask spread in bond market is 2-5 paise and 35-50 paise in equities. For equities, assuming an optimistic elasticity of -0.30 and the transaction cost of 40 paise, the trading volumes will go down by 12%. The trading in bonds can go down by 45% assuming an elasticity of -0.15 and transaction cost of 5 paise, and these are the most optimistic predictions!

The projected revenues of 7000 crores will be severely hit, given the lower trading volumes. In case of Sweden, expected revenues of 1,500 million Swedish kroner from turnover tax were far higher than the actual figure of 50 to 80 million Swedish kroner per year. Moreover, the significant decrease in the number of players and trading volumes will expose the market to imperfect conditions and make it more susceptible to price manipulation by cartels. With lesser players the adjustments will be faster and this will further increase volatility. If this happens the nobler purposes of budget will be defeated.

A recent study in U.K. by Institute for Fiscal Studies suggests that the share prices increase on reduction of stamp duty on transactions. It is estimated that the Transaction Cost elasticity of share prices is -0.20 for Sweden and -0.21 for Finland. These figures suggest the equities can have a long-term price drop of 5-10%, and the bond markets will stagnate. There can be far reaching consequences of the long-term fall in share prices in the determination of average market level.

Unfortunately imposition of Transaction Tax might not be the best answer to FM's intentions of generating revenues and weeding out volatility from Indian Capital Markets. Such mechanism can benefit only under uniform taxation structure across all competing markets, which is not the case currently.