Global telecommunications giant Vodafone should be one of the success stories of investing in India. Instead it is a cautionary tale about barriers to foreign investment the country badly needs.

Vodafone’s entry into the fast-growing market was well-timed and profitable. In 2007, it paid $11.2 billion for a two-thirds stake in Hutchison Essar. Now its mobile subscribers in India have increased more than fourfold to 127 million.

But then came the tax bill: Indian officials slapped the company with a $2.5 billion capital gains charge for the purchase, and alarm bells started ringing.

It was an interpretation of the country’s tax law without precedent, an attempt to raise money on a transaction that took place outside India, and even more controversially taxing the buyer rather than the seller, a Chinese firm. Since then, the government has opened retroactive tax investigations into hundreds of other deals involving foreign companies.

“We have received feedback from many foreign investors that the growing unpredictability in India’s tax policies creates unquantifiable risks in investment planning,” the ambassadors of the United States, Britain, the European Commission and four other countries wrote in a letter to India’s finance minister. “We are concerned that this uncertainty could affect the confidence of those thinking of investing in the Indian market, who may seek an alternative destination for FDI.”

Those fears appear to be well-founded.

Foreign direct investment, or FDI, which measures long-term investments by companies, dropped in India by more than 31 percent last year to less than $24 billion. By comparison, investment in China rose by more than 6 percent to $101 billion, and Brazil overtook India as an investment destination with a 16 percent jump of its own.

Meanwhile, most of the money is going not into the infrastructure India so desperately needs, such sectors as power and transport, but into services, computing and telecoms.

‘Unquantifiable risk’

Corruption is one significant obstacle to doing business here. Finding available land to develop in crowded India is another. Farmers unwilling to be thrown off their land — for compensation they said was severely inadequate — have staged protests and put a number of important investments in deep freeze.

But according to Western business leaders and diplomats, one problem stood out above all others: the sheer unpredictability of doing business in India.

“What most deters investors is unquantifiable risk,” said one foreign business leader who spoke on the condition of anonymity for fear of harming his business interests. He complained about murky laws and poorly defined regulations that leave bureaucrats with the power to make arbitrary and sometimes opportunistic decisions, and that make investment expensive and risky. “There is a love of opaqueness and ambiguity.”

Kaushik Basu, the Indian prime minister’s chief economic adviser, said a couple of big-ticket investments, by South Korean steelmaker Posco and BP, could push the FDI numbers back up in 2011, but he admitted the drop in 2010 had caused some “soul searching” within the Indian government.

Basu expressed optimism that rules restricting FDI in certain sectors, such as multi-product retailing, would be relaxed. He said some restrictive rules, especially around customs procedures, had been streamlined in the budget.

But he acknowledged that many rules were baffling and that the biggest and perhaps most important reform, to make India’s bureaucracy function smoothly — to improve the “ethos of business governance” — looked daunting. “It is slow, sluggish. The bureaucracy is cumbersome. And if you could just clean this up, you wouldn’t have to do very much else,” he said. “But it is such a cobweb of different people’s decisions.”

Dan MacEachron, head of U.S. real estate company Hines in India, said the lack of transparency was a major impediment. “People trying to make long-term capital investments in India face uncertainty,” he said, “because there can be a tendency to change and shift rules, regulations, legislations in somewhat unpredictable ways.”

One long-standing complaint of foreign investors has been the difficulty to exit from a joint venture with an Indian company. On Thursday, India’s commerce ministry relaxed the rules after more than 15 years. Foreign companies will no longer have to seek the permission of their Indian partners and the government if they want become a fully owned operation in India.

But Tarun Das, the former head of the Confederation of Indian Industry, says there are still too many hoops to be jumped through when investing in India.

“There are too many players in India, no centralized decision making,” Das said. “It takes 28 different permissions to just set up a hotel in India.”

Still, the Indian economy is expected to grow at an almost 9 percent rate this year. Countries such as Britain insist the story is still one of a “glass half-full,” and many business leaders talk in glowing terms of the importance of the Indian market and the spirit of innovation and entrepreneurship here.

GE’s success story

One of the most successful foreign companies here is General Electric, which has operated in India since 1902 and has interests in transportation, energy, health care and financial services. But even its bullish chairman and chief executive, Jeffrey Immelt, admitted to some frustrations during a visit in March.

The American conglomerate has also spent a decade trying to land a substantial contract to replace India’s fleet of diesel locomotives, but the deal to build 1,000 of them over 10 years has been tied up in an endless series of bureaucratic wrangles.

“We have invested for a long period of time for the opportunity to successfully bid on a competitive basis to modernize the railways of India,” Immelt said. “If there is an open bid and we lose, I can live with that . . . but to not even have a chance to bid has been frustrating for sure.”

GE’s plans to follow up the landmark 2008 civil-nuclear deal between the United States and India by building nuclear reactors here were also stymied after the Indian Parliament passed a law last year threatening huge liabilities to suppliers of equipment as well as plant operators in the event of an accident.

The World Bank ranks India 134th out of 183 countries for the overall ease of doing business. But when it comes to enforcing contracts, India’s rank plummets to 182, below Angola and better only than East Timor.

The ‘old India’

Investors see promise in India — it came second to China in a 2010 U.N. survey of where multinational companies see as priorities for investment. But when it comes to actually putting the money down, things get harder.

“The world’s companies are beating a path to India’s door, but not as many as could or should actually go through that door,” said a diplomat from a country whose private sector invests significantly in India, speaking on the condition of anonymity to preserve relationships.

About 20 foreign firms that supplied goods and services for last year’s Commonwealth Games are still owed a combined $70 million. The money is tied up, and much of their equipment is impounded while the Indian government conducts a laborious investigation into whether there was corruption surrounding the games.

Again, ambassadors from eight nations put pen to paper.

“The long delay in settling these matters in damaging India’s national reputation, denting the confidence of foreign business, and raising doubts about the enforcement of contracts,” they wrote to Finance Minister Pranab Mukherjee in mid-February.

India hopes to raise $500 billion through public-private partnerships in the next five years to upgrade its infrastructure. Concerns about partnering with the Indian government and hedging long-term currency risk make that goal look ambitious, and Akash Lal, a partner with McKinsey, said he expects a “significant shortfall” in funding of 30 percent.

Twenty years after India liberalized its economy, some bureaucrats still hark back to the attitudes of the “old India,” with little sense of obligation to get business deals done or that foreign investment is truly in India’s interests, business leaders say.

Basu, who joined the government from Cornell just over a year ago, said he had found many hardworking, committed and high-quality people within government, but he said they often get bogged down in the system and do not always deliver.

“It is like getting a bunch of ace motorists and drivers,” he said, “and getting them locked in a traffic jam, so you don’t get to see their skills on display.”