Junk the traditional attitude towards tax incentives and adopt incentives given on a focused and selective basis
In the run up to Budget FY16, there have been speculations, expectations, apprehensions and wish-lists from all quarters. But since the Modi government stormed to power on the plank of economic growth and job creation, it will be of particular importance to see how this budget sets the tone for achieving these strategic goals. Expectations are high that the budget will unveil initiatives to promote manufacturing, crucial to ensure high growth with job creation. The government has recently launched the Make-in-India mission (MIIM) as “a lion’s step towards making the country a destination for global manufacturing business”. Indeed, a number of measures have also been announced to make doing business in India easier as part of the mission. But, unfortunately, announcements to revive special economic zones (SEZs)—which could be central to the MIIM—are still pending. The critical question is, “Will there be announcements to restore some tax incentives to SEZs in this budget?”.
The SEZ Act—launched in 2006 with great expectations—was the first giant step towards promoting large-scale industrialisation. The accompanying table shows that despite changing global conditions and unstable policies, it has made phenomenal progress in terms of employment and investment, based on the incentives offered by the government. But after the MAT and DDT incentives were withdrawn in 2011, it has become difficult for SEZs to attract new units. The table shows that the number of SEZs has declined sharply, and more than 15,000 hectares of the SEZ land has already been denotified since 2012. This means that a large chunk of industrial land has been diverted to mostly real estate use. The available data shows that over 57% of the processing area in notified SEZs is lying vacant. Can India, with its manufacturing ambitions, afford this?
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Ever since the new government has taken over, there have been hints that the SEZs will be revived. After the MIIM was launched in September, these expectations were further fuelled. However, no announcements have come. It was recently reported in the media that the budget is likely to kick-start financial services SEZs, the first of which is to come up in the Gujarat International Finance Tec-City GIFT) in Ahmedabad. The National Institute of Public Finance and Policy that vehemently criticised SEZs for revenue foregone in the past seems to have recommended several tax incentives to these SEZs. But the fate of a large number of SEZs, covering over 56,000 hectares, remains uncertain.
Further, surprisingly little mention has been made of SEZs on the MIIM website. Is it that no complementarity between the two is seen? In the present global scenario, when industrial capital is becoming increasingly mobile, SEZs can be a potentially strong tool to promote investment in particular by foreign investors. Restoring fiscal incentives and integrating them with the MIIM will be vital to promote high value-added manufacturing. This calls for three fold policy measures.
One, adopt a smart approach to tax (or even MAT) incentives. It is time that we drop the ‘all or nothing (horizontal) approach’ to tax incentives and adopt smart incentives that are selective and focused. This means that the incentives should be linked to priority industries as are covered in the MIIM.
In a comparative analysis of SEZs in Korea, Taiwan, and China, I find that all these countries have used tax incentives imaginatively to promote industries of strategic importance. In Taiwan, for instance, in the initial phases of SEZ evolution, all export processing zone (EPZ) enterprises were exempt from taxes for a period of five years. During the 1970s, traditional export items ceased to be eligible for tax incentives; only the upcoming export industries could avail them. In the late 1980s, the focus of incentives shifted to technology-intensive industries. In China, the early SEZs aimed at attracting any type of investment activity but later the focus shifted to high-tech industries which were considered eligible for tax benefits. South Korea has a differential tax regime within its zones wherein tax incentives differ across industries. It must also be noted that in most countries, the first year of production (not approval) is counted as the first year of tax holiday for SEZs units. This benefits technology-intensive, risky industries in entering into SEZs.
Two, allow domestic market sales (DTA) by SEZ units, after the payment of corresponding taxes on the raw materials that they have foregone. This practice is followed in many countries including the USA, China and the Philippines. In the cases where there are no domestic suppliers, DTA sales may be allowed without any payment of duty. One caveat is that the SEZ units will continue to pay income tax on the profits from sales to DTA units. DTA sales strengthen SEZs’ linkage with regional industries and facilitate technological transfer from SEZs to domestic companies. Under various RTAs, imports of agreed products from partner countries to India enjoy nil or negligible duties. But the SEZ policy subjects all SEZ exports to DTAs to the full range of duties. This is a perfect recipe to export jobs from India.
Finally, don’t approve new SEZs unless they are located in NIMZs. Location of SEZs in NIMZs will create economies of scale and better backward linkages with domestic industries.
The new government has promised growth and job creation. Reviving economic activity in SEZs with imaginative policy making and political will may be an easy way to deliver on that pledge.
The author is professor in Indian Studies at Copenhagen Business School