Kenbuck's Inside India Newsletter: The Taxes with Potential Future Effects

This report is from this week's CNBC's "Inside India" newsletter, which brings you timely, insightful news and market commentary on the emerging powerhouse and the big businesses behind its meteoric growth. Like what you see? You can subscribe here.

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In 1696, King William III of England introduced a radical new tax on his subjects to raise state revenue: under the decree, every household in the country had to pay a levy based on the number of windows in their house. This generally means that the bigger the house, the higher the tax.

Despite his progressive intentions, the tax failed to raise enough revenue for the king, as people boarded their windows to reduce their tax liability. In the long run, this policy was a net negative for the state, which had to fight epidemics of typhus, smallpox and cholera due to lack of ventilation.

So, what does window tax have to do with India today?

Earlier this week, India's finance minister surprised markets with a move she said would "deepen the tax base."

Nirmala Sitharaman, presenting her Seventh Budget, increased the tax on trading futures and options to 0.02% and 0.1% respectively - representing an increase of 60%. Further, the minister increased the capital gain for stock market investors from 15% to 20% in a year. Long-term investors will also pay a revised rate of 12.5% ​​on gains above 10%.

Borrowing a page from 17th-century England, India's finance ministry hopes the levy will change behavior and prevent an "uncontrolled explosion" in the derivatives market, where retail investors account for 41% of total trading volume.

What could be cause for concern for the government is if stock market traders have effectively become gamblers instead of getting rid of their unintended negative consequences as they try to reduce their tax burden.

For now, the tax hike overshadows many of the positive developments emerging from the budget. Foreign investors have liquidated nearly $1 billion worth of Indian equities in the two days since the budget was announced, and traders have been sending stocks lower every day since then.

"The lack of populist spending is in line with our expectation, although the increase in capital gains tax for equities is against our expectation of no change," Morgan Stanley's Chief India Economist Upasana Chachra said in a note issued immediately to clients. The budget was unveiled.