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Tax is an important consideration for all investors, including tax-sensitive institutional investors like investment companies and investment advisors. Any attempt to increase tax liability is likely to draw the ire of the investor community due to its inverse impact on their performance. In our recent study, we investigate one such attempt by the Indian government to bring foreign portfolio investors (FPIs) under tax purview and show the influence of FPIs in emerging markets.

Prior studies document that foreign portfolio investments in emerging markets benefit economic growth and, among others, have contributed to elevating the deprived populace to a better standard of living. Governments in emerging markets formulate policies to attract and retain foreign portfolio investments, consequently making them influential stakeholders in the financial market.

Although prior evidence suggests that FPIs can indirectly influence host government policies, we ask whether FPIs possess a direct market-based means of influencing government policies in emerging markets. To address this question, we investigate the equity trading behaviour of FPIs in India, the subsequent stock market implications, and the Indian government reaction following the threat of imposing the controversial Minimum Alternate Tax (MAT) in 2015.

Minimum Alternate Tax in India

Initially introduced in 1987, MAT is an alternate mechanism to ensure “zero-tax companies” in India pay at least 18.5% tax on their net profit. However, despite several attempts by the government and the tax department, FPIs largely avoided any MAT liability by taking advantage of double taxation treaties. Without clear guidelines, the applicability of MAT was a significant policy uncertainty for FPIs. To clear this uncertainty, the then Indian finance minister Arun Jaitley, in his budget address on 28th February 2015, announced that FPIs would not be liable for MAT for their future transactions from 1st April 2015. While this cleared FPIs of their future tax liability, there was still uncertainty regarding their past transactions.

The tax uncertainty escalated when the Indian Tax Department issued assessment orders to several FPIs to the tune of billions of dollars for their past MAT liability at the end of March 2015. Given the severity of this issue, some FPIs approached the dispute resolution panel of the Indian Tax Department, with six of them filing a writ petition before the Bombay High Court. Consequently, a high-level committee was set up, and on whose recommendation the Indian government on 1st September 2015 announced that FPIs would not be liable for any past MAT liability as well.

We focus on the period from March 2015 (MAT threat date) to September 2015 (uncertainty resolution date) and beyond to investigate the impact of the controversial policy announcement on FPIs’ equity trading and its implications on the stock market.

The effect of tax threat

To quantify the effect of MAT threat on FPI, we use a quasi-experimental empirical analysis and compare FPI’s net equity trading in the most (treatment group firms) and least affected firms (control group firms) surrounding the MAT threat date. After controlling for several push and pull factors that affect FPI equity trading, we observe a sudden and significant market withdrawal by FPIs in the postMAT threat date. The difference-in-differences estimation reveals significant and material outflows – a daily withdrawal of approximately INR 5.81m (US$ 91,941.38) of market capitalisation for an average firm in the treatment group compared to a similar firm in the control group. This translates to approximately INR 247 billion (US$ 3.91 billion) of withdrawals by FPIs over the April-August 2015 period.

We observe several adverse stock market implications of FPIs’ abrupt and sizeable withdrawal. We find evidence of a significant increase in the proxies of volatility, such as implied volatility, realised volatility, and volatility risk premium surrounding the MAT threat date. Similarly, using several measures, we find a significant reduction in several measures of market liquidity (liquidity ratio, illiquidity index (Amihud), and turnover ratio) among treated firms after the MAT threat date. Overall, our results paint a picture of the disruptive impact of FPIs’ sudden withdrawal from the market.

We further investigate FPIs’ equity trading following the uncertainty resolution date. Interestingly, we observe a gradual and slow recovery in the immediate period after September 2015. Thus, compared to the exit reaction, our results show that the resolution of policy uncertainty does not necessarily lead to a sudden and material FPIs’ inflow.

Policy lessons for emerging markets

Using an unexpected tax policy announcement that threatened to impose retrospective taxes, we observe a sudden and material exit by FPIs from the Indian financial market. This dramatic response led to disruptive effects on liquidity and volatility on the overall stock market. Moreover, we do not observe any immediate material increase in FPIs’ inflows even after the resolution of the policy uncertainty.

Our study implies that tax advantage is one of the important attractions for FPIs in emerging markets. Any policy change that increases their explicit tax liability may result in severe withdrawal of funds, instigating severe negative stock market implications. These negative effects could have played a key role in coercing the government to reverse the proposed MAT change. Policymakers in emerging markets could do well by taking due care in formulating, announcing, and implementing policies that directly affect the expected payoff of FPIs.


Journal article

Marshall, A., Farag, H., Neupane, B., Neupane, S., & Thapa, C. (2022). Tax Threat and the Disruptive Market Power of Foreign Portfolio Investors, British Journal of Management, 33(3), 1468-1498.

This article has 1 comment

  1. Well, you can’t bite the hand that helps you feed yourself. Adam Smith was ahead of the Indian Government. He said a merchant was a citizen of the world and it was futile to tax try to tax him. Rather, a Sovereign should collect a full rent from his lands. What are the land values of Bombay, Delhi, Madras and Calcutta etc, I wonder? Let the birds of mobile capital fly where they may – but they must needs pay rent where they perch.

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