CNBC's Inside India newsletter: The tax with unintended consequences

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The big story

In 1696, King William III of England implemented a novel tax system to increase government revenue. The tax was based on the number of windows in each household's home, with larger houses paying a higher tax.

Although the tax aimed to advance the monarch's goals, it did not generate enough revenue due to people taking measures to reduce their tax burden, such as boarding up their windows. In the long run, the policy proved detrimental to the state, as it faced epidemics of typhus, smallpox, and cholera caused by inadequate ventilation.

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

This week, India's finance minister announced a surprise measure aimed at expanding the tax base.

Nirmala Sitharaman, in her seventh Budget, increased the tax on trading futures and options to 0.02% and 0.1%, respectively, marking a 60% hike. Additionally, the minister raised the capital gains tax for stock market investors who cash in within a year from 15% to 20%. Long-term investors will now pay a revised rate of 12.5% on gains, up from 10%.

The Indian finance ministry aims to curb the rapid growth of the derivatives market by introducing a tax on retail investors, who make up 41% of total trading volumes.

If stock market traders try to reduce their tax burden, rather than abandoning their gambling behavior and its unintended consequences, it could lead to government concern.

The tax hikes in the Budget have overshadowed many positive developments, causing foreign investors to liquidate nearly $1 billion worth of Indian equities in two days and traders to send stocks lower every day since the announcement.

Although the increase in capital gains tax for equities is against our expectation of no change, the lack of populist spending is in line with our prediction, stated Upasana Chachra, chief India economist at Morgan Stanley, in a note released to clients immediately after the Budget was unveiled.

Will the government's objective be met through the tax, even if investors disregard the initial discomfort?

The increase in short-term capital gains tax from 15% to 20% will discourage excessive trading activities, while the rise in long-term capital gain taxes from 10% to 12.5% is negatively perceived by the market in the short term, according to Siddhartha Khemka, head of retail research at broker Motilal Oswal.

Not everyone is convinced.

"Michael Langham, an emerging markets economist at Abrdn, stated that while this move by regulators may help reduce some of the speculative nature of the market, it is unlikely to significantly deter retail investors. This action is part of a broader effort to control financial stability risks in equity markets, and it's possible that additional measures may be taken to mitigate retail investor risks."

In fact, modern Britain could inspire the risk for regulators.

In 1974, the U.K. implemented a stamp duty tax on every transaction, which now generates over £3 billion ($3.9 billion) annually. However, this tax has resulted in more speculative risks and negatively impacted the stock market.

Since the 1990s, spread betting and CFDs, which expose traders to significant gains and losses, have experienced a surge in popularity. Unlike stocks, these products do not result in ownership, allowing traders to avoid paying trading tax.

The Institute for Fiscal Studies claims that the tax contributes to reducing the valuation of the U.K.'s highly profitable companies.

The tax on Indian stock markets may be beneficial in the long run due to the high valuations currently being traded.

Need to know

The Indian government is likely to ease restrictions on Chinese investments in certain sectors, such as solar panels and battery manufacturing, where India lacks expertise. This move marks the first step in improving economic ties between the two neighbors, which have been strained since clashes in the Himalayan border in 2020.

JPMorgan's chief emerging markets economist, Jahangir Aziz, believes that India must identify new drivers for economic growth as it continues to expand rapidly. According to Aziz, it will be challenging for India to maintain its 6% to 7% growth rate solely on the basis of public infrastructure and services exports.

The deadly Nipah virus has resurfaced in Kerala, India, resulting in the death of a 14-year-old boy over the weekend. First identified in Malaysia 25 years ago, Nipah is known to have a high case fatality rate of 75% and is considered a potential pandemic threat. Health authorities in Kerala are closely monitoring the situation.

What happened in the markets?

Despite a 12.1% increase in the benchmark this year, the Indian stock index has fallen by 0.65% in just five days.

The Indian government bond yield has decreased to 6.95% due to the reduction of the forecasted deficit for this year to 4.9% of GDP from 5.1%.

This week on Biz Focus Hub, Raghuram Rajan, the former governor of the Reserve Bank of India, stated that in order to attract investment in high-value sectors, India must prioritize investing in education and skilling.

He informed CNBC that if you examine the budget again, the main concern would be the significant investment in infrastructure compared to the limited investment in human capital development.

Suman Bery, vice chairperson at Niti Aayog, stated that it would be incorrect to assume that the Budget was a result of the 2024 election outcomes.

Bery stated that India has been gaining jobs, but these jobs have been of low productivity. To speed up its growth rate, India must shift its labor force into higher productivity jobs. This will necessitate numerous structural changes.

What's happening next week?

Next week, Chinese imports subject to U.S. tariffs will become effective. Central banks will also reveal important decisions on the data front.

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