The Indian equity market is plagued by low interest by retail investors. So, it is good to note that the government now is clearly concerned about its perceived apathy towards the equity markets. The measures taken in Union Budget 2012 to channelise savings in financial assets is a testimony to this. Currently, there are around 20 million demat accounts and 38.5 million folios of mutual funds in India, suggesting 5 per cent equity penetration. With one of the largest pools of domestic savings, the equity penetration is abysmally low. Retirement and pension money has not found its place in equity markets. I am a firm believer that equity markets provide unparallel opportunity to create widespread prosperity in the country. However, the measures taken by the government are insufficient and do not appreciate the problems faced by retail investors while investing in equities.
The key reasons for Indian equity to remain underappreciated by domestic investors are:
1) Asset classes of choice: gold and real estate have given superlative returns with much lower volatility in comparison to equity markets over the past few years;
2) Investors have to rely on the kindness of strangers (brokers, advisors) to scan profitable investing opportunity/stock while in case of the other two asset classes, it can be evaluated individually.
3) Corporate governance issues in India have been overweighing in the mind of retail investors while investing in the domestic equities. This concentrated controlling, shareholders coalition creates agency issues such as reluctance to distribute cash flows, excessive investing in growth projects empire, complex structures /tunneling, and voluminous, yet opaque information; while other minority shareholders or independent board members are disinclined or unable to challenge them.
If we intend to foster equity culture in India, the above mentioned problems require a radical solution: providing an incentive to equity shareholders in form of Allowance of Corporate Equity (ACE), a form of allowing nominal interest on equity capital tax deductible. This should be coupled with a compulsory dividend payout policy, around 25 per cent or more by corporates. ACE allows deduction on shareholder funds (long term bond rates of government securities) from corporate taxability. The compulsory payout of the profits will ensure that accounting profits are aligned with the cash generated by the company. To me, this is the best way to separate the wheat from the chaff in corporate India, encouraging long term investment in Indian equities and channelising domestic saving in the productive financial assets.
Where ACE comes into play
A closer look at the last fiscal results of the constituents of BSE 500 Index (excluding 59 government companies), throws an interesting fact about the dividend policy of India. We have not included government-owned companies as the government plays a dual role of being the policy maker on taxation related to dividends and is also a majority shareholder in these companies. The study shows that average pay out is around 25 per cent but this data is skewed by a few companies having very high dividend payouts. On aggregate, companies accounting for 50 per cent of the total profit, of above mentioned universe, pay just around 10 per cent of their profit as dividends while keeping the balance 90 per cent at disposal of controlling shareholders. Investors have witnessed huge volatility in the profitability of the companies over a business cycle, partly explained by the cycle itself and partly due to corporate misgovernance. In a layman’s term, there is a possibility of an overstatement and understatement of the profit by the corporate, whichever suites their business and capital structure need. Minority investor has to steer through the layers of financial statements which usually results in voluminous annual report, meager payouts and, in few cases, nothing. Last but not the least, in absence of compulsory dividend and allowance policy, investors are subjected to the vagaries of the capital markets and price action as a sole measure of wealth creation. This may not be the best possible solution for the long term investing. ACE, coupled with compulsory dividend, is a strong self-fulfilling mechanism which combines strong enforcement and incentivises the corporate towards fair accounting and eliminates debt bias, thereby also progressing towards much safer banking system in the country.
The international experience of ACE or its variants has been very encouraging. Countries such as Belgium, Chile, Greece, Columbia, Venezuela and Latvia have some variants of ACE or compulsory dividend system working. Brazil has successfully implemented ACE coupled with compulsory dividend since 1996, a model that should inspire India. Each country has drawn its inspiration from the uniqueness of the problem it has faced and adopted systems which best suited the circumstances. Recently, Chinese Security Regulatory Commission (CSRC) expressed strong opinion about low dividend payout by the listed entities and framed rules for dividend payout for listed companies as well as IPOs. In one of its recent working papers, IMF has indicated that various governments across Europe are discussing to adopt some form of ACE in order to reduce the debt bias that has led to meltdown of the global financial markets.
Let me preempt some potential issues which may follow on issues of compulsory dividends. First, it reduces the ability to reinvest, especially for Indian mid-and small-size firms, where the cost of rising equity is quite high. A study in Brazil, where compulsory dividend policy is in place, has suggested that this had no impact on long term reinvestment capabilities of the firm. Moreover, cost of equity improves dramatically when inflows from institutional investors spread across market, thereby, increasing the investible universe, which is usually concentrated in large cap stocks. Secondly, this would result in lower tax collections. Following measures have been taken by the government: Raising the effective tax rate by at least 10 per cent by reducing the tax sops available under various schemes, increasing Minimum Alternative Tax (MAT) and improving tax compliances. A strong incentive system in the form of allowance for equity is a credit due to the corporate India and the shareholders. Statistics of the BSE 500 companies show the total profit after tax at around $43.5 billion, tax collection of $15 billion and dividend payments of $8.5 billion for FY11. A back of envelop calculation would suggest that cost of implementing ACE with compulsory dividends, to public revenue, in terms of lower tax collection can be close to $3 billion per annum, a small number, considering the economic benefit the superior corporate governance can bring for all the stakeholders. In the short run, this can be reduced further, by granting allowance to new or incremental equity investments only. This implementation will bring economic benefits, increased investments, higher wages and higher economic growth which are urgently needed. Indian authorities have to wake up before the competition among nations intensifies to attract global long term capital for financing the country’s need.