Free zones: Benefits and costs

Free zones have emerged on the scene as a planning tool to help boost economic development. They have their advantages, but their policy pitfalls too.

Since antiquity, governments, emperors, kings and queens have been providing traders and investors with special sites offering respite from normal import-export tax regimes and regulations in return for a steady stream of much needed revenue for the public purse. Before modernity, such places were concentrated in the Mediterranean basin, at Delos in Greco- Roman times, and in Venice, Genoa and Marseilles during the Middle Ages. By the 19th century, they had spread to Southeast Asia. But it was not until the latter half of the 20th century that so-called free zones made their mark as deliberate tools of economic development, most notably in China in 1979 when one of the most famous free zones of all was set up at Shenzen.

Nowadays there are several hundred free zones around the world, and the MENA region has a fair share of successes, from Dubai's media and Internet cities that caught the early wave of the e-economy, through Egypt's Gulf of Suez all the way to the Tangier Free Zone.

Located on the African side of the straits of Gibraltar, just 14 km from Europe, the Moroccan port of Tangier, a town that has long attracted writers, musicians and tourists from around the world, is now using free zones to build a new reputation as a business hub.

The Tangier Free Zone (TFZ) reflects the emerging trend of moving away from classical export-processing zone development towards zones with a multisectoral development approach. It was inaugurated in 1999 and became operational in 2000. Located inland near the airport, it covers some 345 hectares and houses some 400 companies. In the 10 years since its inception, the industrial users of the free zone have invested some €500 million in their facilities. Some 40,000 jobs have been created, and as Jamal Mikou, managing director of TFZ, explains, these workers have added significantly to Morocco's exports. In 2008, the free zone accounted for a tenth of Morocco's industrial exports, totaling €1.2 billion.

Free zones are also considered a lever for boosting technological skills, particularly in the auto-components industry. Major clients such as Yazaki, Sumitomo and Delphi now supply the automobile industry, and new demand is likely, thanks to investments by Renault. Tangier's free zone is one of several successful such areas in MENA, though the landscape is also dotted with slower performing ones. While most have filled up in terms of investment spaces, their effect on development has been less clear. What do successful free zones have in common and how can they be made to benefit the wider economy?

Since a major objective of creating free zones is to increase exports, most free zones around the world are either ring-fenced enclaves exempt from national import and export duties or formally operate outside the customs area of their host country. Governments often add other benefits to the package, such as tax, regulatory, administrative and financial incentives.

Free zones generally fall into one of four categories: free trade zones, export processing zones, special economic zones, or industrial zones. Free trade zones, typically located near seaports or airports, mainly offer exemptions from national import and export duties on goods that are re-exported. Local services gain, though there is little, if any, value added to the goods traded. Export processing zones go a step further by focusing on exports with a significant value added, rather than only on re-exports. Special economic zones apply a multisectoral development approach and focus on both domestic and foreign markets. They offer an array of incentives including infrastructure, tax and custom exemptions, and simpler administrative procedures. Industrial zones are targeted at specific economic activities, say media or textiles, with infrastructure adapted accordingly.

In the MENA region, there are around 73 such free zones, and 17 MENA countries have some type of free zone in place or in development.

MENA free zones have tended to focus on trading (importing goods and re-exporting to other destinations), but lately there has been a trend away from traditional free zones towards the more channeled variety of special economic zones and industrial zones, in part to boost value added and revenue, but also to promote economic diversification and generate more employment.

Take the free zone at Jebel Ali, a deep port in Dubai established in 1985 and widely considered to be among the most successful. It started as a trans-shipment port where large vessels unloaded goods that smaller ships would move on to other ports around the Gulf. Activities and goods involved were exempt from import duty. Jebel Ali triggered a wave of new free zonetype initiatives and the UAE now accounts for over a third of all MENA free zones.

This has led UAE governments, especially Dubai, to establish industrial zones to target particular sectors. There are now 24 such zones, with Dubai Media City being one of the best known. Six of Egypt's nine free zones were established before 1994. The three established since then include the famous Media Production City, and one large special economic zone called Northwest Gulf of Suez. Since 2007, Egypt has been concentrating on more focused industrial zones, known there as investment zones. These depend less on tax incentives and more on facilitating administrative procedures, quality infrastructure and private sector management to attract investment.

As of June 2008, free zones in Egypt employed nearly 136,000 people. In 2007/2008 they accounted for 20.3% of Egypt's total exports, and FDI in free zones represented 9.5% of Egypt's total FDI in 2007/2008. Jordan has seven free zones, with the Aqaba special economic zone the most successful. It has attracted more than 300 companies and an estimated $400 million of investment. Three new zones have been established since 2001.

What incentives?
As a general rule, free zones in the MENA region provide regulatory incentives. In many zones, the authorities act as a onestop shop, cutting related red tape and simplifying administrative procedures. A further regulatory incentive is an exemption from limits on foreign ownership. In many Gulf countries, such as Kuwait, Bahrain and the UAE, land ownership regulations are relaxed either through renewable long-term leases or outright waivers. Similarly, labour market regulation can be eased, particularly regarding the employment of expatriates, as in the case of Jordan and Kuwait, or waiving regulations on limited duration contracts, such as in Tunisia. In some cases, foreign exchange regulations can also be foregone, as in Morocco, Syria, and Tunisia.

Free zones often offer programmes of fiscal incentives that go beyond those offered to investors in the wider economy. Algeria, Egypt, Kuwait and the UAE, for example, offer complete exemption from private and corporate income taxes. Lebanon, Morocco and Yemen offer corporate tax holidays of variable duration. As for the private income taxes of foreign employees, Yemen offers full exemption, Jordan a 12-year holiday and Tunisia a flat income tax rate of 20%.

Subsidies are not so prevalent. Financial incentives take the form of low land rental and utilities rates, as in Egypt, Lebanon, Tunisia, Kuwait and UAE, state aid for acquiring land, as in Morocco, or subsidies for training expenses, as in Jordan's Aqaba zone.

Designing a free zone
But do free zones actually work? Some investments may have taken place anyway, though the existence of zones does spur governments to develop their investment policies, satisfy investors and promote opportunities for new businesses. They also create jobs: the World Bank estimates that free zones account for just over 1.5% of national employment throughout MENA as a whole. But take a closer look and it is not hard to see how these zones can end up adding to the fiscal burden of governments, distorting the direction of investments in the wrong areas or creating complacency in extending economy-wide reforms.

The zones in the MENA region that have performed best over a long period tend to be in countries where the enabling environment is relatively favourable anyway, in terms of macroeconomic and exchange-rate policies, private property and investment laws, labour market regulations, productivity of human capital and rule of law. Incentives and economic zones supplement, but cannot replace, a good enabling environment. Zones should not be seen as a substitute for a country's larger trade and investment reform efforts.

The trouble is, while some MENA countries have made encouraging progress in areas such as infrastructure and skills development, results in institution building and reform have been mixed. In fact, informality and administrative inefficiency are still too widespread.

Another question is whether the fiscal incentives that most MENA countries offer are effective. On the one hand, such incentives are rule-based and relatively transparent. On the other hand, they result in foregone public revenue. Thorough cost-benefit analyses should be done prior to establishing the zones and sunset clauses should be used. Furthermore, fiscal incentives could be better tailored to promote capital investment, such as by using investment tax credits and exemption from duties on capital goods, rather than, say, using tax holidays that cannot be guaranteed to spur productive investment at all.

The race to attract global capital as inward investment is trying, especially in today's crisis. But while there may be valid reasons for setting up zones that offer more attractive investment regimes than the local general regime, governments should avoid fostering zones that no longer perform well or promote development. Indeed, should particular zones prove successful, the public objective should be to extend the regime and its benefits to the rest of the economy.

Zone programmes should target a wide assortment of economic sectors, including commercial and manufacturing activities and professional services, such as warehousing and trans-shipment.

To reduce the burden placed on public resources and increase the efficiency of zones, the private sector should be encouraged to help develop them and be allowed to operate under market mechanisms. Several governments have developed and managed zones that have been less effective than those of their private counterparts.

Moreover, though free zones operate as offshore locations, they are geared to international activity. To avoid unfair competition, preferential duties on sales to the rest of the host economy and other discriminatory practices should be resisted.

Free zones have many merits and have boosted investment in many MENA countries. More zones are in the pipeline and still more will emerge in the years ahead. However, bringing in investment is only one, albeit vital, step in a long journey. The ultimate goal must be to make those investments work to the benefit of the wider economy. Michael Fodor

Nada Farid of the OECD Directorate for Financial and Enterprise Affairs contributed.

References

OECD (2010, forthcoming), Business Climate Development Strategy, Paris. Contact Alan Paic at daf.contact@oecd.org

Booz Allen Hamilton (2008), "The Rise of Economic Zones in the MENA Region: A Telecommunications Perspective".

Foreign Investment Advisory Service (2008), "Special Economic Zones: Performance, Lessons Learned, and Implications for Zone Development".

OECD (2008), "Incentives and Free Zones in the MENA Region: A Preliminary Stocktaking, 2008 Update".

© OECD Observer, No. 275, November 2009




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