…the dilemma of Tax Incentives and Regulatory Exemptions in Special Economic Zones
Regional and international trade agreements, increased awareness of emerging markets, and a deep desire to be seen as world-class, are driving many companies to establish subsidiaries in developing economies. Perhaps no place has seen this rush more immediately than Africa, where so much potential remains untapped.
What makes Africa a particularly attractive area for foreign direct investment (FDI) is the availability of tax breaks, exemptions, and other incentives in many countries across the continent. The combination of tax incentives and a trend toward reduced barriers to trade have spurred an unprecedented wave of FDI to Africa over the past decade.
This trend is leaving many economists, political leaders, and development specialists wondering: Are these incentives really helping to boost the economies of Africa and its people, or are they just creating more opportunities for businesses to hoard profits while doing little to improve the lives of local people?
Special Economic Zones (SEZs) have been popping up in more and more countries worldwide with the hopes of boosting business. These unique economic areas for multinational companies are often seen as a way for them to gain access to suitable markets without all the rigmarole of becoming a fully-fledged member of that country’s population. The growing number of successful companies attracted by these attractive tax structures is leading many owners and managers to conclude that it is more cost-effective to invest in Africa through a subsidiary than through direct investment in the home country itself.
The appeal of SEZs lies in the relaxation of restrictions on trade and the ability to set up shop under tax-friendly rules. For example, in an effort to attract foreign investment, some governments have exempted certain sectors of their economies from applicable duties and import taxes. In the case of Ghana’s Free Zones, any company engaged in manufacturing, trading, or infrastructure activities is allowed to bring into the country duty-free most capital items required for production. Labor that has been sourced locally has also been exempted from income tax for a number of years.
Another advantage is the ability for companies to operate in a certain area without jeopardizing their reputation or employees. For instance, some countries have set up special “donut” forms of protection that allow companies not registered in the country but operating within a certain region to be exempt from local regulations, taxation, and other legal obligations regarding activities that could endanger the reputation of their home-country operations. In this case, companies can transfer the risks associated with doing business in a foreign country to their local subsidiaries.
The regulations and tax exemptions introduced by these countries have essentially made it possible for multinational enterprises to have the best of both worlds. On the one hand, they can source inputs locally and benefit from modern technology, cheap labor, or unutilized industrial capacity. On the other hand, they can sell finished goods around the world without worrying about tariffs or operating under different sets of rules in each country they deal with.
The benefits to investors are clear: By locating production overseas in countries with lower wage costs, the potential for greater growth, and more international exposure, some companies can save money on labor costs. In addition, they often pass along some of these savings to consumers in the form of lower prices. Rising wages at home due to increased competition and diminishing low-wage labor pools can also force companies to move production abroad in order to compete globally.
Some countries that have been attracting sizable amounts of FDI into their economies are using their tax incentives to attract companies. Others are looking to take advantage of the cheap, inexpensive labor force that is available in Africa to support the expansion of their businesses. To encourage this, some countries in Africa have even gone so far as to give new investors a percentage of the profits from local activities.
However, economists and experts in international development continue to disagree about these incentives’ long-term effects on Africa’s economies and populations. While some contend that the inflow of FDI and the establishment of SEZs have the potential to bring much-needed jobs and development to the continent, others are concerned that the emphasis on luring foreign investors may be put ahead of developing local industries and fostering sustainable economic growth.
Tax incentives and special economic zones (SEZs), which are currently popular in Africa, are criticized on the grounds that they may eventually be detrimental to local economies. For instance, when governments provide tax benefits to foreign investors, they might be forfeiting potential income that could be used to finance public services and infrastructure improvements. In addition, others concern that SEZs could foster inequality and lead to a “race to the bottom” in terms of wages and working conditions because they establish a distinct legal and economic framework within these zones.
Despite these reservations, there are no indications that the trend in Africa toward tax breaks and SEZs will abate. Africa will probably continue to be a popular location for foreign direct investment as global corporations look for new markets and developing economies. The challenge will be for governments to strike a balance between attracting foreign investors and developing local industries to ensure sustainable economic growth and prosperity for their people.
Strategic Tax Leverages for Special Economic Zones
- Technology Transfer: SEZs and tax incentives can also help to promote technology transfer and knowledge-sharing between foreign investors and local businesses. By bringing in new technologies and best practices, foreign companies can help to improve the productivity and competitiveness of local industries.
- Infrastructure Development: In order to attract foreign investment, many countries are investing in infrastructure development in and around SEZs. This can include building new roads, airports, and ports, as well as investing in energy and telecommunications infrastructure. These investments can help improve the country’s overall business climate and create new economic growth opportunities.
- Export Promotion: Many SEZs are specifically designed to promote exports and help local businesses to access new markets. By offering tax incentives and other benefits, these zones can help to reduce the cost of doing business and make it easier for companies to export their goods and services around the world.
- Economic Diversification: By attracting foreign investment in a range of industries, SEZs can help to diversify the local economy and reduce dependence on a single sector or industry. This can help to create a more stable and resilient economy that is less vulnerable to external shocks or downturns in specific sectors.
- Job Creation: By attracting foreign investment, companies can create new jobs and boost employment in the local economy. In some cases, SEZs are specifically designed to attract labor-intensive industries, which can help to reduce unemployment rates and provide opportunities for local workers.
That said, many trade analysts contend that the availability of tax incentives and other benefits may actually be a disadvantage for developing countries. In addition to the loss of potential public revenue from tax breaks, critics also raise concerns about their long-term effects on development and inequality.
Inversely, special economic zones and tax incentives actually play an important role in attracting foreign investment and helping to build a range of industries in developing countries. This can help to promote economic growth and diversification by providing opportunities for new business ventures that might otherwise struggle to get off the ground or compete with established players.
Howbeit, there is a concern that pure tax incentives may not be enough to create successful local industries. In Africa, for instance, many zones have generated a high amount of interest but failed to yield substantive results. Some experts suggest that tax incentives in Africa might not be well-targeted and do not offer enough of a competitive edge to attract investors. SEZs thus give foreign companies an unfair advantage over local players because they have the potential to provide them with much-needed capital and support during the start-up phase of their business ventures. As other major corporations begin to enter the market, local businesses could struggle to compete with large international conglomerates that can afford superior technology and marketing campaigns.
Governments should thus be agile and monitor the long-term effects of SEZs on their economies to cure the unfair leverages for external investors against local industries. Policymakers should avoid being too restrictive with the tax regulations for locals vis-a-vis external investors in these zones.
To make special economic zones more efficient, countries should focus on improving their overall business climate through a number of different measures. For example, governments can help to improve the investment environment by simplifying administrative procedures and reducing red tape around businesses. They can also put in place strategies to promote healthy competition and fair-trading practices to ensure that local companies have a fair chance at competing with foreign competitors. In addition, policies can be developed to help improve the overall quality of education, health care, and other social services.
When we take a look at the special economic zones emerging on the continent, such as the Dawa Industrial Zone in Ghana, we can identify the aforementioned policies being implemented. Such measures are more likely to attract viable investments and local entrepreneurship, creating a more balanced economic development strategy and stronger local industries in the long term. Additionally, this industrial hub makes room for various light and heavy industries across sectors including information technology, manufacturing, and utilities.
Once these key measures are in place (i.e., replicated across the continent), it will be possible to monitor the results of tax incentives and SEZs on the economy and local industries. If there are no practical benefits from these zones and they do not generate enough investment or exports, they may become less attractive and less relevant over time. This can be a great way to ensure that tax incentives actually lead to positive effects on local economies.
The writer is an award-winning financial advisory, trade and transformation consulting pro with almost two decades of enterprise leadership experience across EMEA.