The abolishment of dividend tax in the hands of investors, with a caveat of 12.5 per cent deduction before distribution, elicited cautious cheer from equity players.

It was expected that the Finance Bill 2003 may exempt dividend income in the hands of shareholders and at the same time will not levy distribution tax. The Direct Tax Task Force headed by Vijay Kelkar had recommended this.

The Finance Act 2002 made dividend/income from units taxable in the hands of shareholders departing from mechanism of collection of tax at the time of distribution by the company /mutual funds (as the case may be).

Anup Bagchi, COO, ICICIdirect.com cautioned that the distribution tax of 12.5 per cent is disappointing as markets had not expected it.

Samir Gandhi, partner, Deloitte Haskins & Sells, said: "The Finance Bill  has only partly met the expectations and the recommendations by exempting dividend income/income from units in the hands of shareholders distributed after 1 April 2003."

"However, the income will now be taxed at the time of distribution at the rate of 12.5 per cent. It is to be noted that effective rate will be higher at 12.81 per cent as the distribution tax is to be increased by a surcharge of 2.5 per cent as applicable to companies."

"Administratively, this is simpler. However, it would have been better if the recommendations of the Kelkar panel were fully accepted. The issue of whether tax credit is available to the shareholders situated outside India in respect of distribution tax paid in India is debatable," Gandhi added.

According to Sunil Shah, managing Director, HDFC Securities, the combination of no dividend tax in the hands of the recipient combined with no long-term capital gains tax is the main trigger for investment.

Sudhir Kapadia, partner, Bharat S Raut, KPMG member firm, said: "There has been a flip-flop in the scheme of dividend taxation. The dividend distribution tax (DDT) is now in the hands of coprorates. Moreover, DDT is generally not eligible for tax credit by foreign investors against home country tax. This will, however, benefit high net worth individuals who will be tax sheltered at  their marginal rates (33 per cent) against 12.5 per cent DDT payable to corporations in which they are shareholders."

The corporates had reacted favorably to changes in tax laws relating to dividends in the past. In July 1997, when tax incidence on dividends was shifted from the equity shareholder to the corporate balance sheet (resulting in a reduction in the effective tax on dividends), corporates raised their payouts.

This is also logical when one considers the context of family-managed and -owned companies in India.

Such companies are not inclined to pay large dividends because of the subsequent tax liability on the families that owns a majority of the holding.

It is believed that corporates would have reacted with higher payouts than it did between 1997 and 2001 if the Kelkar Committee's recommendation were implemented given that the committee has suggested zero tax on dividends and not just a shift in incidence as in 1997.

Tax reforms can be a driver for equity markets if the inequitable tax regime on equities is abolished. Such a measure would improve household savings in equities and cause higher dividend payouts leading to stronger stock performances.

Analysts argue that one of the major reason for the fall in equity savings in the past decade has been caused by more than just the discriminatory tax treatment of equities.

Domestic investors have suffered in dealing with equities, the 10-year compounded annual return on the Sensex is 2.8 per cent, while the 5-year compounded annual return is -0.1 per cent and, consequently, risk aversion is high.