Tax reforms can indeed be the direct driver of the equity markets simply by removal of the inequitable tax regime on equities.

Such a measure would improve household savings in equities and cause higher dividend payouts leading to stronger stock performances.

In a report by JM Morgan Stanley, it has been argued that paying dividends could be a rewarding experience because high-dividend payers do not produce inferior earnings growth.

In fact, they generally produce stronger stock price performance and are less volatile as shareholders tend to hold on to such companies.

Analysts argue that 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 Bombay Stock Exchange sensex is 2.8 per cent, while the 5-year compounded annual return is -0.1 per cent and, consequently, risk aversion is high.

Risk aversion is complicated and operates at multiple levels (politics, economic growth, financial markets, etc), but tax treatment is easy to address. The JM Morgan Stanley report believes that the removal of the incongruity in tax burden on equities and fixed income would cause a re-direction of savings into equities away from fixed-income investments.

"Our argument is that unbiased tax treatment of equities (removal of tax on dividends and long-term capital gains) would likely cause corporates to raise the dividend payouts, which, in turn, would lower stock price volatility and result in higher returns," the report stated.

The inequitable tax regime on equities has had two consequences -- low dividend payouts -- India's long-term average dividend payout is just 27 per cent; and, a low share of household savings in equities -- which is estimated at only 3 per cent of the household balance sheet, it says.

It is worth mentioning that corporates have reacted favorably to changes in tax laws relating to dividends.

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 family-owned companies in India.

Such companies are not inclined to pay large dividends because of the subsequent tax liability on the families that owns the majority shares in the companies. The families retain control of the cash whether the cash resides on the companies' balance sheets or in the families' accounts.

It is believed that the corporate sector would react with higher payouts than it did between 1997 and 2001 if the Kelkar Committee's recommendation are implemented.

The committee has suggested zero tax on dividends and not just a shift in incidence as in 1997. Dividends payouts influence both returns and the risks associated with returns. The stocks of high-payout companies are less volatile, and tend to have much lower share turnover (greater shareholder stickiness – which is good for any management trying to ensure stock price performance), and, above all, produce higher returns.

Apart from higher returns, the stocks of companies that pay high dividends also carry the benefits of lower share turnover and volatility.

Companies that consistently pay high dividends are rewarded with a greater share of sticky shareholders. The share turnover of non-payers is 3.5 times higher than the share turnover of dividend payers  Many companies complain of the lack of long-term ownership among public shareholders. Not unpredictably, the stock prices for low-dividend-paying companies exhibit greater volatility.

The magnitude of difference is unexpectedly large. The average gap between the volatility of low paying (bottom quintile) and high paying (top quintile) for the past 10 years is a good 2 per cent. This extra volatility is equivalent to higher risk premium and, therefore, the lower return outcome on stocks of companies with low dividend payout is not entirely surprising.

Higher earnings growth, lower stock price volatility, greater shareholder stickiness and more stock price appreciation make for a strong justification for higher dividend payouts.

If the tax-related disincentive to pay dividends is removed, the case for higher payouts would become too good to resist, the JM Morgan Stanley report states.