Is SEZ the God that failed?

Imagine the following economic reform that can really surge manufacturing and exports. It promises single window and speedy approvals. The approval committee is empowered and meets frequently and regularly. The policy promises a stable tax regime and is guaranteed by an Act of Parliament. The Act itself is thoroughly discussed and debated for five long years (unlike many other bills of Parliament), so that all infelicities are ironed out, and best practices are incorporated in its rules. The power of Parliament behind the policy is supposed to signal stability, irreversibility and predictability. This is important for investors, since they don’t want to get caught in retrospective or unpredictable changes to taxes. They need clarity.
Such a reform is not in the realm of imagination. It was indeed passed by India’s Parliament in 2005, during the reign of United Progressive Alliance-1, after being initiated by the previous National Democratic Alliance government. The Act was preceded by five years of tumultuous debates, including wild accusations from detractors who said that the law would deprive the exchequer of trillions of rupees. But its passionate proponents fought the fight all the way to the Union cabinet, and the Special Economic Zones (SEZ) Act was passed.
The SEZ model was inspired by China’s SEZs which were critical instruments of its export-led growth. Before China, there were the shining example of the East Asian tigers and their roaring exports. To provide Indian manufacturers a competitive edge, you needed to unburden their taxes (not experienced by their competitors) and you needed to give them world-class infrastructure. You needed to enable foreign investment too. All this was the vision behind building SEZs in India, islands of excellence and efficiency, free from burdensome inspector raj or arbitrary taxes (which anyway cannot be exported). The proponents were so sure of this vision that the spirited commerce secretary said then, “Hang me, if you don’t see five lakh new jobs in SEZs within the next three years.”
Alas, 10 years later, this significant reform is a story of unfulfilled promise. Look at the data. As of September 2014, there were 564 formally approved SEZs. But only 192 were operational. Barring a few, we haven’t seen big investments. The incremental employment generated was about 11 lakh in nine years. Exports from SEZs grew by only 4% in 2013-14 and decreased by 6% in the next year. A Comptroller and Auditor General (CAG) audit last year found that 52% of the land allotted has remained idle, even though permissions were given as far back as 2006. One severe indictment from CAG was that 57% of SEZs were in the IT (information technology) and ITES (information technology-enabled services) sector, and only 9.6% were for multi-product manufacturing sectors.
The implicit allegation is that since the section 10A/10B tax holiday had expired, the IT sector simply preferred to shift to SEZs to enjoy renewed tax benefits. It wasn’t new investment or job creation. Of course, there may be exceptions to this, such as the excellent Mahindra World City anchored by Infosys outside Chennai.
Where is the high-value manufacturing that was supposed to come up? Sadly, one high-profile SEZ led by Nokia is also defunct. It has not led to large-scale investment or employment, especially in high-value manufacturing, nor has it created a surge in exports. Even the investment that came into SEZ in many cases was not new and incremental, and might have materialized in the absence of the Act. It did not lead to the development of backward areas, an objective that was probably misplaced for the instrument, anyway.
The SEZs were also plagued by the negative image that they have simply become tax havens. This perception is misplaced, as shown by a study done by the Indian Council for International Economic Relations (ICRIER). But the other impression that only real estate business is thriving inside the SEZs is largely correct. And that it led to a lot of land grab (as partly confirmed by the CAG report).
May be it was unfair to have conceived of SEZ as the silver bullet. But it’s important to understand why this policy failed. Here are some possible reasons.
Firstly, the breaking of the tax promise. This was a cardinal sin. The income tax benefits were neutralized by the introduction of the 20% minimum alternate tax (MAT) and the 20% dividend distribution tax (DDT) in 2011-12. Secondly, the absence of complementary infrastructure outside the SEZs, like port connectivity, proved to be a dampener for manufacturing investment. The development commissioners did not prove to be as proactive in assistance as their SEZ counterparts in other countries in getting land, clearances and plug-and-play infrastructure. Thirdly, export incentives like Focus Product and Focus Market Schemes were not extended to SEZs, making them less attractive. Exports from outside SEZs, called the domestic tariff area (DTA), enjoyed duty drawback and other duty neutralization. Fourthly was the tsunami force of free trade agreements (FTAs). Today, it is better for you to manufacture in Thailand and get duty-free access to India than to manufacture in an Indian SEZ and face a 14% import duty barrier. This will be a huge deterrent to Make in India. May be we should be signing an FTA with all the SEZs first.
The SEZ policy needs a comprehensive overhaul. Piecemeal repair won’t do, and a non-partisan holistic approach is a must. May be we can declare the whole country as an SEZ?