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    SEZs: Intention without execution

    India has witnessed a huge rush from private sector companies keen to set up Special Economic Zones (SEZs). The new SEZ Act was approved in February 2006, and the government has already received over 100 applications. Before the new legislation, SEZ-related laws were scattered among different acts and rules. The new legislation provides a uniform SEZ policy and comprehensively covers all aspects of establishment, operation and fiscal oversight. The government has also given greater operational freedom to the Development Commissioner as the key authority managing the SEZ. However, the most important change is related to tax incentives.

    Well intended…
    The promotion of SEZs is an attempt to deal with infrastructural deficiencies, procedural complexities, bureaucratic hassles and barriers raised by monetary, trade, fiscal, taxation, tariff and labour policies. These structural bottlenecks affect the investment climate adversely by increasing production and transaction costs. Since countrywide development of infrastructure is expensive and implementation of structural reforms would require time, due to given socio-economic and political institutions, the development of SEZ is seen as an important strategic tool for expediting the process of industrialisation.

    Despite the recent pick-up, India’s share in world goods exports has been very small – at 0.9% for 2005 – due to the widely known gaps in the business environment. SEZs have long been seen as a means for India to create bigger inroads into small and medium scale manufacturing. Improving the business environment on a nationwide basis and providing a competitive platform to India’s entrepreneurs will take time. SEZs, however, can quickly help create high-quality infrastructure in pockets, providing a liberal and supportive business environment, and thus kick-start the much-needed push for manufacturing exports. They allow the government to experiment with the liberalisation of labour laws. SEZs can also provide scale-related advantages via the creation of clusters, reducing manufacturing costs. SEZs can be particularly helpful for small and medium-scale entities that cannot afford to set up captive infrastructure facilities, but can share the costs in a large group. Finally, they can attract foreign capital and technology.

    Current status of upcoming SEZs
    Till date the government has notified 63 SEZs. The Ministry of Commerce might restrict the total number of SEZs approval at 100.

    State wise distribution of outstanding SEZ projects
    State No. of SEZs Details available for
    no. of projects
    Investment (Rs bn)
    Maharashtra 70 24 610.9
    Karnataka 63 28 263.4
    Andhra Pradesh 62 22 379.1
    Haryana 50 14 1,257.6
    Gujarat 40 29 850.2
    Tamil Nadu 30 12 86.5
    Uttar Pradesh 23 5 66.2
    West Bengal 21 8 153.4
    Orissa 13 8 605.4
    Rajasthan 11 1 0.3

    …but not well executed
    Although SEZs as a concept appear to be the right solution to encourage India’s manufacturing exports, the government’s current approach may not be the best way to achieve the much-needed push to boost India’s manufacturing, particularly in the SME sector. The following are some of the issues arising from the government’s current approach:

    1. SEZ applications were driven by tax benefits: A large number of new SEZs being planned are primarily aimed at winning tax benefits. Under the new law, units in SEZs will be 100% exempt from corporate income tax for the first five years; 50% exempt for the next five years and, for the final five years, 50% of the profits ploughed back will be exempt from tax. The new law provides exemption for 15 years compared with 10 years under the old law. Another factor that has attracted corporates to SEZs is that existing tax exemptions for export-oriented units set up in non-SEZ areas such as Software Technology Parks (STPs) are due to expire in financial year 2009. As per the current policy the tax exemption to STPs is available only if 30% to 50% of the production is exported and it is a net foreign exchange earner.

      According to the Ministry of Finance, the government may end up losing indirect and direct tax revenue of Rs 939 bn over the next four years (averaging Rs 234 bn per annum, or 0.4% to 0.6% of GDP) on account of existing/new export oriented units shifting to SEZs.

      It is foreseen that companies will simply relocate to SEZ to take advantage of tax concessions being offered and little net activity will be generated. The act will lead to a large-scale land acquisition by the developers, displacement of poor farmers and meager compensation being handed over to them with no alternative livelihood. SEZ will be built on prime agricultural land with serious implication of food security.

    2. Scale-related advantages unlikely: The key purpose of SEZs is to build scale-related advantages. However, most of the SEZs currently being planned are minuscule in size. The new law allows the minimum area for the SEZ area to be 1000 hectares (3.9 square miles) for multi-product zones, 100 hectares for product specific zones and just 10 hectares for IT, gems & jewellery and biotechnology zones (subject to minimum built-up area norms).

      We believe that with the rapid globalisation of manufacturing scale, small SEZs appear to have outlived their relevance in today’s environment. Among the ones announced, there are probably only two medium-scale SEZs being taken up for development. Both these zones are being set up by Reliance Industries, India’s largest private sector company.

    3. Labour issues: The new SEZ law is unlikely to address the critical issue of labour flexibility. A restrictive labour law environment has been one of the major hurdles to the development of the Indian manufacturing sector. The most restrictive central government regulation is one that requires all employers with more than 100 employees to gain compulsory government approval (normally a long drawn-out process) before retrenching workers or closing part of an enterprise. This provision has not changed since 1982. The original draft of the new SEZ law intended to give state governments the freedom to allow implementation of flexible labour laws within the SEZ area. However, before the final approval from the lower house of Parliament, the government was forced to drop this clause in the face of leftist opposition.

    The debate…
    Although the Ministry of Commerce is in favour of the policy with arguments that SEZs are expected to attract investment of Rs 1,000 bn including FDI of Rs 250 bn and will create additional 0.5 m direct jobs by December 2007, there are arguments that the SEZ Act was framed without giving adequate thought to most of the ancillary issues. No exercise were undertaken to ensure that legal institutions are in place for massive land acquisition. No long-term strategy was drawn to counter the socio economic consequences of the scheme. No serious research was conducted on how SEZ will affect the regional economy, how much fertile land will be lost, how many farmers will be affected and what the tax implications of SEZs will be.

    Also, the sectoral breakup of SEZ approvals shows that 61% of the approvals has been given in the Information Technology (IT) sector. The manufacturing sector accounts for only one-third of the total approvals. This pattern is worrisome. In view of declining competitiveness of the manufacturing sector, the focus of the SEZ policy needs to be making India a preferred destination for manufacturing.

    The bottom-line
    While the new SEZ law may have resulted in significant rise in applications from the corporate sector, from a macro perspective this might not be the best solution. Many of these proposed investments could be mere substitution of investments that would have otherwise taken place outside the SEZ area. The new SEZ investments are unlikely to provide the much-needed fillip to Indian small and medium manufacturing sectors’ competitiveness. The best solution would be for the government to rework the SEZ policy to facilitate the development of large employment generating SEZs, without hurting the country’s exchequer and dissuading all vested interests. Another possible solution would be to set them up in the barren land or in land with low agricultural productivity.

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