On March 16, 2012, Pranab Mukherjee, the Indian Finance minister, proposed a retroactive amendment to India’s tax laws[1], which would allow the Indian government to impose a capital gains tax on the indirect sale of Indian assets among non-Indian entities. The proposed retroactive tax is an effort to shore up India’s fiscal budgetary woes and would allow the government to tax “offshore” transactions dating back to 1962.[2] Unsettlingly, the proposal is also a direct rebuke of the Supreme Court of India’s judgment issued in Vodafone International Holdings B.V. v. Union of India & Anr., holding that the Indian taxing authority did not have the power to tax the sale of a holding company incorporated outside of India, which held a controlling interest in an Indian telecommunications company, from a non-Indian seller to a non-Indian buyer even though the transfer indirectly involved Indian assets.

While there is nothing wrong with a legislature responding to a court decision by amending laws prospectively—especially in response to a law that allowed entities conducting business in India to escape taxation by adhering to strict corporate formalities—there is something disturbing about amending laws retroactively, overruling the decision of a Supreme Court and penalizing persons who were in full compliance with existing law. Such a move creates a cloud of uncertainty with regard to the rule of law in India, which in turn shakes investor confidence in the world’s largest democracy. Indeed, the SENSEX (India’s version of the NYSE) has plummeted following Mr. Mukerjee’s proposal and has yet to recover. Further, business leaders have expressed concerns to Dr. Manmohan Singh, India’s Prime Minister, warning that the proposed retroactive tax is a “sudden and unprecedented move” that is “now prompting a widespread reconsideration of the costs and benefits of investing in India.” This is especially troubling news for India given that its economic growth is decelerating and the government has been displaying an old penchant for protectionism lately.

India’s Roller Coaster Relationship With Foreign Investors

India’s leaders initiated socialist and protectionist economic policies upon its independence in 1947 due to the fact that opening up to trade with a foreign investor, the British East India Company, effectively led to a 200-year colonization.  Until 1991, the government played a major role in the economy, engaging in inefficient import substitution and sometimes engaging in outright hostile policies towards foreign investors, such as in 1977 when the government demanded that Coca-Cola give up its secret formula to Indian competitors or leave the country. The result of these protectionist policies was an embarrassingly slow rate of growth from independence until the 1990s that was mocked for years as the “Hindu rate of growth.”

Of course, today, perceptions have certainly changed. India’s growth is not mocked but lauded. The positive attitude towards India’s economy among foreign investors can be traced back to the early 1990s when Dr. Singh, then the Indian Finance Minister, enacted significant reforms that liberalized India to a market economy. Since then, the country has demonstrated healthy growth and grew rapidly in the period between 2003 to 2008. The country has garnered tremendous goodwill with investors and is still viewed as having tremendous potential for further growth. That Jim O’Neil coined the phrase BRIC certainly does not hurt nor does the growing presence of Morgan Stanley and Goldman Sachs.

However, there are some signs that the love affair between India and foreign investors may not last and that the protectionist India of old is making a reappearance. The economy has been decelerating since 2008 and the country is facing a budgetary conundrum. In addition, along with the proposed retroactive tax, India has made some puzzling protectionist moves that may scare foreign investors away. In December, Dr. Singh caved to political pressure by putting the government’s plan of allowing foreign companies, like Walmart, to invest in Indian retail manufacturing on hold. Also troubling to foreign investors, the government recently suspended environmental clearance to Posco, a South Korean steel company, that has been trying to build a plant in India since 2005.

It’s Time For Dr. Singh to Lead By Restoring Investor Confidence in the Rule of Law

Just as the memory of India as a slow growth country has faded away in popular consciousness, one hopes that protectionist policies and bad governance will not render the BRIC India—the India of opportunity— a distant memory as well. At the very least, India must scrap its retroactive tax proposal because nothing could be more damaging to foreign investor goodwill than indicating that full compliance with existing Indian law is subject to penalization by the legislature. The negative effects of the erosion of the rule of law will outweigh the budgetary windfall gained by imposing a retroactive tax in the long run.

Surely, no one understands this better than Dr. Singh who holds a Ph.D in economics from Oxford, and deserves credit for transforming India to the vibrant economy that it has become today. But it remains to be seen if Dr. Singh, who turns 80 in September, is willing or able to step up to the challenge, especially in the political climate of India, which can make the sleaziest American politicians look stately (e.g., from 2004 to 2009 one quarter of India’s parliament were facing or had previously faced criminal charges). Dr. Singh is held in such meek regard lately “that a common joke at meetings is to request that all cell phones be switched to ‘Manmohan Singh mode’—which is to say, rendered inaudible.”

India is blessed to be thought of fondly in the eyes of foreign investors despite the costs that graft and corruption impose on foreign businesses.  It should not squander this goodwill away by reverting back to protectionism and hostile policies that got the country nowhere for the decades following independence.  This is especially true when there is reason to suspect that a significant portion of the ultimate windfall in imposing a retroactive tax may be pocketed away by corrupt officials. It is time for Dr. Singh to switch back to Finance Minister mode and take the actions necessary to maintain India’s goodwill with foreign investors. At a minimum, this requires Dr. Singh to stand up strongly against the proposed retroactive tax and the imposition of retroactive laws altogether before foreign investors decide that the uncertainty and costs of investing in the world’s largest democracy outweigh the allure.