What makes India an unusually exciting place to live in is the "apne pair pe apne kulhadi (axing your own feet)" ingenuity of its politicians and bureaucrats. It would seem that policymakers around the world would welcome a gift which came with the following warning: if you follow this policy, there will be large employment creation, large tax revenues, and, unlike the rest of the population, this particular source of tax revenue will have 100 per cent compliance, and that the revenue would be obtained exclusively from the rich.

The present system of foreign portfolio investment in India is the following: only institutions, approved by Sebi, can invest in the Indian stock market. And even these institutions have to wait at least a year, and sometimes more, before they are given an FII licence to invest in India.

These management fee-receiving institutions cannot be based in India because if they were, they would not be classified as an FII! Foreign-based individuals (Indian and foreign) are forbidden from investing in India. In keeping with our policy of "our ex-pat nationals are criminals unless proven otherwise" the poor Indian based abroad is de facto not permitted to invest directly in Indian markets. (Indian banks and Indian fund managers refuse to open stock market-related accounts for NRIs because the RBI reporting requirements are too onerous.)

This control freak FII policy has several possibly unintended consequences. By requiring foreign investors to not be based in India (a policy unique to India among all markets, emerging or developed), the Indian government is losing on three fronts: large-scale employment in the financial sector, the development of India as a financial centre, and large-scale tax revenues.

In exchange for sacrificing these objectives, the government of India is gaining zilch, zero. Which is why the policy is, at a minimum, immensely stupid.

The proposition being documented here is very straightforward - perhaps because of inertia, or worse, the FII policy of the government is a massive own goal. One would think then that easy sources of tax revenue, particularly from rich people, and particularly from such wasteful activities as stock market investments, would be the first order of priority. Sadly, this is not the case; because of our hard-to-decipher policies, India lost close to Rs 10,000 crore (Rs 100 billion) in tax revenue last fiscal (2005-06).

So how exactly are we axing our feet? The stock market creates two sets of income: short-term capital gains and fee income for the managers. When an FII investor comes via Mauritius, it avoids paying the short-term tax of 10 per cent. What this institution/bank/fund manager cannot avoid paying tax on is its fee income. While most of these financial institutions (and hedge funds) have subsidiaries in Mauritius, or Canary Islands (or other tax havens), none of them has head offices in these countries. The fee income goes back to the head office (in the US or the UK, or wherever) and the fund manager pays taxes in the head office country.

Now we come to the Indian axe trick. We require all foreign investors in the Indian stock market not to be based in India! Let me phrase it in a different, but equivalent, fashion. We state to the outside world that yes, India is generating wealth, yes, you can come and profit from it, but no, you cannot be based in India, or have India-based offices making the decisions. All the profits that you make are yours, and please pay the taxes on the fees that you generate to needy governments like the US and the UK.

A simple calculation will suggest the magnitude of the horror wielded by the Indian axe. (The average gain or loss made by the stock market has been added to net FII flows.) As of end-March 2005, cumulative net FII flows in India were Rs 145,000 crore (Rs 1450 billion). Taking non-repatriated profits into account, this FII holding was Rs 205,000 crore (or approximately $45 billion).

Over the next year (April 2005 to March 2006) the Indian stock market increased by 74 per cent. The profits made by FIIs in 2005-06 are estimated to have been close to Rs 150,000 crore (Rs 1500 billion). The fee income generated with these profits is approximately Rs 30,000 crore (average of 20 per cent fees based on 2 per cent base fee plus 15 to 25 per cent of profits).

Indian corporate tax on this fee income (rate of 33 per cent) would have yielded a cool Rs 10,000 crore (Rs 100 billion) to the Indian treasury, enough to finance the first year of the National Rural Employment Guarantee Scheme.

The conventional wisdom (sometimes also clueless in wonderland wisdom) is that this money will not accrue to the Indian government because of tax treaties. For all such CW believers, let me repeat that the Mauritius (or Singapore) tax treaties are irrelevant for these calculations.

This fee income is repatriated from Mauritius to headquarters; the only way that the corporate tax on this income can be avoided is if the income stays in Mauritius forever. Which it obviously does not.

How can the government of India get back its feet? Very simply by removing the restriction that this money cannot enter India unless the money is stamped as a foreign entity.

The "monitoring" of such FII inflow can still be done by Sebi; and the regulatory authority can still require fund managers to report any purchases/sales made on behalf of the foreigners. So nothing, literally nothing, is lost by the GoI by opening the doors of foreign portfolio flows to India-based organisations.

Note that the fees tax will be received by the government even if none of the India-based organisations is actually Indian. So there is no quota requirement here - only the elimination of a rather absurd regulation, a regulation made even more absurd with the passage of time.