SEZ follies

Reintroducing tax breaks for special economic zones is a bad idea

It has been reported that the government plans to renew a fiscal push to Special Economic Zones (SEZs) by reducing the minimum alternate tax (MAT) on units located in these areas from 18.5 per cent to 7.5 per cent. It may be recalled that the MAT had been imposed on these units in 2012 — a signal that they were not delivering in terms of exports. So the apparent desire of the government to re-incentivise production in SEZs needs more scrutiny. In theory, SEZs provide producers – whether manufacturing or services – a business environment matching global standards. With high-quality infrastructure, logistics and other inputs being brought to bear, producers are expected to take full advantage of the economy’s most abundant resources – in particular, labour – to achieve globally competitive costs. One very important dimension of the lure of SEZs is the quality and efficiency of regulatory oversight. They promise to free producers of the cumbersome and costly processes that counterparts located in the rest of the economy are forced to endure. In fact, countries that have had the greatest success with this model, such as Malaysia and China, created dual regulatory regimes, with much of the compliance load being exempted for units in the zones. In Indian zones, however, significant differentiating factors such as flexible labour contracts were not put in place, reducing the competitive advantage of locating in them. Further, goods that were produced in a zone had to be shipped to their export destinations using the same crumbling inland and port infrastructure that producers outside the zones relied on. High logistics costs completely offset any cost advantage that the zones otherwise might have provided. It should come as no surprise then, that the zones proved to be attractive largely to companies in the information technology and information technology-enabled services sectors, which transported their exports through the telecom networks, the one relatively efficient component of infrastructure.

In short, the reality of Indian zones is that they became arbitrage opportunities, where producers took advantage of the tax and other concessions without delivering on the reciprocal commitment to export. There was no reason for the government to continue to discriminate in favour of them; MAT was thus a reasonable step. The point is: nothing has changed since. There is no justification to re-introduce the tax incentive; the lost revenue would be tax expenditure in pursuit of very little.

The government must learn the right lessons from the successful experience of other countries. It is not enough to cluster producers and induce them to export on the basis of incentives. What needs to be done is to provide a holistic low-cost, high-efficiency business environment, which allows producers to use the economy’s most abundant resources competitively.

The SEZ approach can facilitate this under certain conditions — but cannot guarantee it, because there is a larger context in which they must operate. Focus on improving the business environment, whether in the zones or outside; and incentives are best given in the form of quality infrastructure and efficient regulation.