Part 1- Special Economic Zones: Making Them More Effective

Special Economic Zones or SEZs are some geographical regions in which the economic laws are more lax when compared to a nation's domestic economic laws. These liberal laws are put in place to boost the business, increase FDI, increase domestic production and to have more job creation.

Historical perspective and the Chinese success story

Between 1965 and 2005, India built eight tiny export processing zones( a type of SEZ), with very limited success. By contrast, China succeeded in creating massive SEZs. These behemoths have world class power, water, ports and airports, and have become world-class manufacturing clusters. These SEZ were instrumental in making China a global manufacturing hub.

Indian Story

In 2006 we adopted a new SEZ policy. The main provisions of this policy were-

1. Tax exemption for units in SEZs for five years( not even MAT was to be collected),
2. The units were to get a 50% tax break for next five years,
3.  A further five year tax break for reinvested profits, and
4. SEZ developers would also get a tax holiday for 10 years.

Results of this policy change

Instead of creating massive SEZs, this policy encouraged hundreds of small SEZs in every state. These amounted to tax shelters and a grab for land rather than world-class enclaves. No less than 564 proposals for SEZs were approved, but of these only 204 are actually functioning. Most operating SEZs are small IT establishments that are little more than tax havens.

The 2006 Act provided that the minimum size for information technology, jewellery and biotech parks should be just 10 hectares, smaller than even some schools. Size limits were kept especially low for hilly areas, where flat land is scarce. This was a classic case of making SEZs an end in themselves rather than a means to improve competitiveness. China does not create tiny SEZs in the Gobi desert or Tibetan mountains: it creates large ones in areas with the best logistics, infrastructure, financial and transport facilities.

Exports from Indian SEZs rose from $5 billion in 2005-06 to $81 billion in 2013-14. This looks very impressive. But a lot of it is simply trade diversion. Many top IT and jewellery companies shifted their operations to SEZs for the tax break. Since units outside the SEZs continued exporting at a good rate, it is unclear whether the SEZs achieved additional exports or just diverted exports.

Because of such factors, MAT and the dividend distribution tax was imposed on SEZs in 2011-12. Industries protested that this discouraged additional investment. True, but would this fresh investment have been for export diversion or export addition? The operating profit margins of software companies often exceed 20%, so they hardly need tax breaks. Old export units in areas from textiles to engineering, many having very slim operating margins, get no tax breaks. Why should they be discriminated against?