It is now generally accepted that in the real sector, if a tax is placed on multiple intermediate stages of production, it creates distortions. The incidence of a turnover tax (or excise) thus falls on industries where production requires more intermediate stages.

This distorts production in favour of products that require fewer stages of production, and distorts the behaviour of firms in favour of excessive vertical integration. The answer, of course, is VAT, which is a sound tax because it leaves the structure of production undistorted.

The securities transaction tax (or STT) does in the world of finance exactly what a turnover tax does to industry. The unit of production in finance is 'a trading strategy.'

Some trading strategies involve more trading; others require less. The incidence of the STT falls upon those strategies that involve more trading. The STT leads to a distortion in the economy in favour of trading strategies that involve fewer stages of production.

Specifically, the STT is doing substantial damage to the task of achieving correctness of pricing of futures and options, since the trading strategies that force prices back to fair value involve much turnover.

The STT is a wrong tax because it drives up transaction costs--when the very purpose of financial sector reforms is to reduce transaction costs. Is it too small to matter? The best measure of transaction costs is the 'impact cost' when doing trades on the secondary market.

The Economic Survey shows that the impact cost for doing a trade of Rs 5 million in Nifty dropped from 0.27 per cent in 2001 to 0.09 per cent in 2004. This is a gain of 18 basis points. So the spectacular achievements of financial sector policy -- banning badla, introducing rolling settlement, introducing derivatives trading--all added up to a gain of 18 basis points.

Having an STT at 10 basis points implies throwing away more than half of that progress! This is like spending thousands of crores (billions) of rupees to build four-lane highways, which bring down travel time from 27 hours to 9 hours, and then introducing a new checkpoint where trucks lose 10 hours.

Every bad tax starts out small and then snowballs. Customs started at single-digit rates and grew into a Frankenstein. A 30-year effort had to be mounted to get rid of customs duties, a process which is still not done. We are seeing the STT go through this process--the Left wants it raised to new levels.

Once Mr Chidambaram displays his willingness to do bad economics by taxing transactions, he undermines his own moral position when dealing with the truant behaviour of Maharashtra, which also wants in on the party. The gray men of the ministry of finance need to take the high moral ground, to steadfastly do good economics, and never tax transactions.

They should draw inspiration from the Depositories Act, which removed stamp duty for transactions settled in demat form.

Does abolishing the STT require going back to a long-term capital gains tax? No. Customs was a bad tax, and it needed to be removed, without proposing a substitute. Tax policy needs to evolve towards exactly two taxes: the income tax and the GST (including a GST on finance). These two are perfectly able to generate the tax-GDP ratio required for the country.