Special Economic Zones: A Tool for Trade Growth

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A special economic zone is a fenced piece of a country that is treated, for the purposes of customs, tax and often labour and land regulation, as though it were somewhere else. Goods entering it from abroad are not treated as imports and pay no duty; goods leaving it for the domestic market are treated as imports and do. The logic is simple. If a country's tariffs, paperwork and infrastructure make it a poor place to manufacture for export, but changing all of that nationally is politically impossible, then build a small area where the rules are different and let exporters operate there.

India was unusually early to the idea. An export processing zone opened at Kandla in Gujarat in 1965, generally described as the first of its kind in Asia, well before the Chinese zones that made the model famous. Others followed at Santa Cruz in Mumbai, and later at Noida, Chennai, Cochin, Falta and Visakhapatnam. They were not a success. The zones were state owned and state run, approvals still had to be obtained from multiple ministries, infrastructure was poor, and the surrounding economy was so licence bound that the zones were islands of relative freedom rather than engines of transformation. Meanwhile Shenzhen, designated in 1980, grew from a market town into one of the largest manufacturing cities in the world, and Indian policymakers noticed.

The 2005 Act and what it actually offered

A new special economic zone policy was announced in 2000, and it was given statutory form by the Special Economic Zones Act, passed in 2005 and brought into effect with accompanying rules in 2006. The Act was deliberately generous and deliberately simple. Zones could be developed by private parties, not just the state. A single window approval structure was created, with a board of approval at national level and a development commissioner in each zone empowered to act for multiple agencies. Zone units were placed outside the customs territory for tariff purposes. And the tax incentives were substantial: a long income tax holiday on export profits for units, tapering over fifteen years, exemptions from duties on imported and domestically procured inputs, and separate incentives for the developers who built the zones.

The response was immediate and enormous. Hundreds of zones were formally approved and a large number notified, far more than the government had anticipated, and a great many were very small, since the minimum area requirement for sector specific and information technology zones was low. This produced the policy's first structural distortion: the overwhelming majority of investment and employment went into information technology and business services rather than manufacturing. Software firms could satisfy the requirements with an office campus, needed no port and no complex logistics, and were already export oriented. The zones therefore worked in the narrow sense that exports from them grew rapidly, while largely failing at the thing that had justified them, which was building competitive export manufacturing and the mass employment that comes with it.

The second problem was land. Zone developers needed contiguous parcels, often of hundreds or thousands of hectares, in a country where such land is farmed by large numbers of smallholders and where acquisition operated under a colonial era statute offering weak compensation. The resulting conflicts were among the most violent political episodes of the period. The proposal for a chemical zone at Nandigram in West Bengal in 2007 provoked resistance in which police firing killed protesters, an event that contributed to the fall of a state government that had held power for over three decades. A very large zone proposed near Mumbai in Raigad district was defeated by a farmers' referendum. These episodes fed directly into the passage of a new land acquisition law in 2013, which imposed consent requirements and much higher compensation, and made the assembly of large private zones far harder.

Retreat, dispute and redesign

The fiscal case also came under attack. The national auditor and the finance ministry both questioned how much genuinely new investment the zones had attracted, as against activity that would have happened anyway and simply relocated inside a fence to capture the tax break. Revenue foregone was substantial. From 2011 and 2012 the government began clawing back, extending the minimum alternate tax and the dividend distribution tax to zone units and developers, which removed much of the advantage that had been promised for fifteen years. Investors who had committed on the strength of the original terms regarded this as a breach of faith, and a good deal of approved zone land was subsequently de notified. A sunset clause then closed the income tax holiday to units that began operations after 31 March 2020, meaning that the central incentive of the 2005 Act no longer applies to new entrants.

International trade law delivered a further blow. India's export incentives were challenged at the World Trade Organization by the United States, and in 2019 a dispute panel found that several Indian schemes, including the special economic zone provisions and the export oriented unit scheme, were prohibited export subsidies. India had previously been exempt from the relevant prohibition because its income per head fell below a threshold in the Agreement on Subsidies and Countervailing Measures, but it had crossed that threshold. India appealed, and the appeal has been effectively frozen because the WTO's Appellate Body has been unable to function without appointments to fill its vacancies. The practical effect is that the panel ruling is neither implemented nor overturned, an unsatisfactory limbo that nonetheless constrains what India can offer.

Policy has since tried to redesign the model. A committee reporting in 2018 recommended converting zones into broader employment and economic enclaves, dropping the requirement that units be net foreign exchange earners, and allowing easier sales into the domestic market on payment of duty only on imported components rather than on the finished good. A bill to that effect was announced in the 2022 budget but was not enacted, and attention has shifted to other instruments, principally production linked incentive schemes that pay manufacturers directly for incremental output in sectors such as electronics, pharmaceuticals and solar equipment.

The honest assessment is mixed and still argued about. Indian special economic zones account for a meaningful share of national merchandise and services exports and employ a large workforce, which is not nothing. They did not do what Shenzhen did, and the reasons are instructive: China's zones were few, huge, coastal, backed by massive state infrastructure investment and paired with land the state already controlled, while India's were numerous, small, scattered, privately assembled and offered tax breaks in place of ports and power. Zones can relieve specific constraints. They cannot substitute for fixing them.

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