Special Economic Zones in India: growth engines or missed opportunity?

Author: Aradhna Aggarwal, Copenhagen Business School

India’s Special Economic Zones (SEZ) policy, announced in April 2000, has been the single most important initiative ever taken by the Indian government to promote private investment in industrial activity.

Activists of Communist Party of India New Democracy shout slogans during a protest against Special Economic Zone in New Delhi, India. (Photo: AAP)

It is not the first time that India has tried to develop its SEZs. The first wave of export zones started in 1965 and ended in 2000 with little success. The prospects are better this time. The current policy targets private investment in SEZ development and offers several lucrative incentives and features that were not available in previous initiatives.

These early initiatives were also not supported by any legislative framework. Special legislation, the SEZ Act, was enacted for the first time in 2005. The Act evoked immense interest among investors as it provided confidence, stability and the correct incentives.

But, the Act was soon caught up in controversies related to land acquisition, tax incentives and other socio-economic issues. The debate led to anti-SEZ protests throughout the country. Policymakers appeared unprepared to respond to the widespread criticism, and the government seemed to be a house divided.

Fearing the loss of popular votes, the government started diluting the benefits and rolling back the incentives for investors. Still, by March 2012, the number of newly approved SEZs had swelled to 589, with 389 of these already notified.

But the government dealt a significant blow to SEZs in 2012 when it rolled back key tax incentives, including the minimum alternate tax (MAT) and dividend distribution tax (DDT), offered to investors. By 31 December 2015, the numbers of approved and notified SEZs declined to 412 and 329 respectively. More than 15000 hectares of SEZ land was de-notified between July 2012 and January 2015.

The Ministry of Commerce, which had conceived and implemented the scheme, also seems to have moved on. Instead, the Ministry is now promoting the concept of national investment and manufacturing zones (NIMZs).

All of this begs the question as to why India needs SEZs in the first place. In the contemporary world, where global firms are organising their production and trade in increasingly complex global value chains and scout the globe for the least cost locations, SEZs provide a platform for countries to reap the benefits of these opportunities.

SEZs are strategic locations which address structural and institutional bottlenecks arising from infrastructural deficiencies, procedural complexities, bureaucratic hassles and other restrictive policies common in developing countries like India. They offer an enabling investment climate to attract both offshoring and outsourcing activities.

Reviving manufacturing is one of the biggest development challenges that India faces today. The entry and integration of its firms into global value chains can help create the industrial dynamism that India needs.

So how have SEZs actually performed in India? Despite unstable policies and the global economic downturn post 2008, the number of SEZs swelled and gave a big push to employment and investment at the aggregate level.

In February 2006, total employment and investment in SEZs stood at 134,704 and US$888 million respectively. In January 2015, total employment was over 1.5 million while investment was a staggering US$54 billion. The share of SEZs in total exports (including service exports) increased from around 3 per cent in 2005–06 to 19.5 per cent in 2012–13.

Even though 60 per cent of zones are in the IT sector, almost 85 per cent of SEZ land is used in manufacturing. SEZs have been instrumental in promoting new industries such as biotechnology, renewable energy, aviation, electronics and sports shoes. They have also given a major thrust to the engineering and pharmaceutical industries.

Still, uncertainties did take their toll. Actual investment and employment have fallen short of initial projections by 59 per cent and 92 per cent respectively. The winding up of MAT and DDT tax incentives has further slowed down investment and SEZs share in total exports declined to 17 per cent in 2013–14.

What lessons can be learned from this experience? First, SEZs have the potential to accelerate economic growth and diversify the industrial structure. But SEZ policy must be designed to address institutional challenges that pose major obstacles to growth, and it needs to be supported by a transparent legal framework.

Second, tax incentives matter. They can be effective instruments in encouraging private investment.

Finally, strong political commitment is necessary. This must be accompanied by an intense focus on institutional learnings, policy experimentation, institution building and belief in the SEZ strategy, as well as knowledge of the necessary and sufficient conditions for the success of SEZs, and clarity about the vision and objectives.

So what can be done to revive SEZs?

The most important thing is to build investor confidence by restoring the original tax benefits to SEZs with a clear timeline outlining when they will be phased out. In future, any change in the Act should be introduced through amendments passed by the parliament.

Tax incentives must be rationalised and tailored to promote industries of strategic importance. The first year of production should be used as the first year of tax exemptions, rather than the first year after the project is approved, particularly for technology-intensive and risky industries. Firms producing in SEZs must further be allowed to sell in domestic markets, after paying the taxes that they had been exempted from.

The SEZ program should also be integrated with the ‘Make in India’ initiative and NIMZs. There has been significant hype generated around MIIM and NIMZs, but SEZs remain an underutilised plank in these two initiatives.

SEZs have the potential to be a major growth engine for India. The government should act fast to revive them otherwise SEZs will become another missed growth opportunity.

Aradhna Aggarwal is Professor in Indian Studies at Asia Research Centre, Department of International Economics and Management, Copenhagen Business School.