(Note: The following appears in the July issue of Mackinac Center Impact and is an edited excerpt from an article originally published in the June 2006 issue of Reason magazine.)

Bangalore has benefited not just from the central government’s efforts to reduce onerous bureaucracy and red tape, but from its radical reform of the federal tax system, once among the most punitive and complicated in the free world. Now Indian states also have started to simplify their tax schemes, something neither Michigan nor Detroit has found the will to do.

At its peak in the 1970s, India’s top marginal corporate income tax rate was 93.5 percent. This, combined with an 8 percent tax on wealth, meant those who played by the rules could count on effectively handing over their entire profits to the government at the end of the year.

The 1991 reforms dramatically changed this situation. India not only lowered the marginal income tax rate for corporations and individuals to between 30 and 35 percent (not counting deductions); it slashed the wealth tax to 1 percent and abolished the estate tax. The reforms are ongoing and are not limited to the national government: Last year 21 of India’s 29 states joined hands — a major political miracle — to end a bewildering system of multiple state-level sales taxes that even seasoned accountants couldn’t fathom.

Tax reforms, coupled with trade liberalization that exempted all exports from taxes and slashed duties on imported goods, gave a big boost to the information technology industry. The Indian government, acting on the theory that information technology would propel broad-based economic development in the country, has given the industry targeted tax breaks as well. Around 1999, New Delhi declared a 10-year holiday from corporate income taxes for all companies registered in its official software technology parks program.

But special tax breaks, notes Arvind Panagariya, an economist at Columbia University, have at best helped the industry at the margins. "If it were up to me, I’d end them today," he bristles. The fundamental reason for the software boom, in his opinion, was that India abandoned its import substitution approach and made it easier for the information technology industry to acquire cheap equipment from abroad and combine it with cheap, high-skilled labor at home to produce cost-effective global exports.

Like India, Detroit knows how to use the tax code to play favorites. Nearly every large company that has moved to Detroit in the last decade, including Compuware and General Motors, has done so only after being promised hefty tax breaks. But what the Indian central and state governments are also doing — and Detroit and Michigan are not — is reforming the overall tax climate to make it more friendly to enterprise.

According to the Mackinac Center for Public Policy, Michigan is one of just a handful of states that levy a sales tax, a personal income tax and a business tax. The last, called the Single Business Tax, has the most pernicious effect on entrepreneurship and job growth because it taxes firms on their costs and investments, rather than their profits. If a company adds employees, its SBT goes up. If it raises wages, its SBT goes up. If it buys new equipment, its SBT goes up.

Political leaders from both parties have long recognized the perversity of this tax, but they haven’t been able to muster the political will to wean the state off it. (At press time, reformers were making a renewed push to scrap the SBT.) Michigan’s political pusillanimity contrasts sharply with the bold reform of the state sales taxes in India, where leaders divided by language, religion, class and caste managed to unite behind a single tax scheme, even persuading local politicians to forgo what they have long regarded as their God-given right: selectively handing sales tax exemptions to favored groups to build their fiefdoms.

On top of all the state taxes, Detroit adds several of its own, including a 5 percent tax on residents’ utility bills (which goes, bizarrely, to the police); a 2.5 percent personal income tax on residents; a 1.25 percent personal income tax on people who work in Detroit, but don’t live there; and a 1 percent corporate income tax. As if that were not bad enough, the city charges such a high assessment on property when it is sold that few buyers are willing to pay it, freezing the real estate market and forcing owners to burn or abandon their houses. For a family of four making $50,000, Detroit is the eighth highest-taxed city in the nation.

Radical tax cuts along with deregulation awoke the world to Bangalore’s information technology potential. It is unclear where Detroit’s potential is; only a free-market discovery process can reveal it. But whatever it may be, it will remain hidden so long as Detroit’s onerous tax burden and regulations keep scaring businesses away from the city.

#####

Shikha Dalmia is a senior analyst at the Los Angeles-based Reason Foundation and an adjunct scholar with the Mackinac Center for Public Policy, a research and educational institute headquartered in Midland, Mich.