Special economic zones: the end of an era?

In the late 1970s, Chinese Premier Deng Xiaoping launched a reform of China's national economic setup. The Chinese economy, which had long been closed to the rest of the world, was going to be opened gradually to foreign investments.

In the next decade, China proceeded to establish special economic zones (SEZ) in Shenzhen, Zhuhai and Shantou in Guangdong province and Xiamen in Fujian. The whole province of Hainan was added to the list in 1988 while the Pudong New Area in Shanghai was designated a special economic zone in 1990.

Economic and technological development zones (EDTZ) are another form of an SEZ which refers to the coastal areas or open cities that have been dedicated for industry and trade development. These areas were established at around the same time as the original four SEZs.

A model for other regions

As the name suggests, a special economic zone enjoys some privileges that other areas in the country do not have. The central government adopts special policies for these areas, allowing SEZs to thrive under a special economic management system. They are listed separately in the national planning and have province-level authority on economic administration.

SEZs, which are geared primarily to the export of processed goods, play a dual role in the Chinese economy. They are "windows" in developing foreign investment and importing advanced technologies, but they are also "radiators" that could help accelerate the pace of inland development.

Because of the very nature of SEZs, they are places where foreign investment is most concentrated, where more than 200 multinational enterprises have invested in over 400 industrial projects. The economy in SEZs are also developing most rapidly in China, with major economic indices rising higher than the national average. And because of their location, there is a huge development potential in these areas due to their proximity to transportation hubs and major economic cities.

Companies that are allowed to set up in these SEZs are primarily either Sino-foreign joint ventures and partnerships or wholly foreign-owned enterprises, in keeping with the original goal of establishing these areas, which was to attract foreign investments.

Perhaps one of the greatest impacts that the SEZ has had on Chinese economy is that in the beginning, these areas were the equivalents of laboratories, where reforms could be implemented in a limited area. If these reforms failed, the damage was limited. If they succeeded, the reforms could be, and often were, adopted by other regions in China.

Negative aspects

The SEZs have been widely trumpeted as one of the highlights of Chinese economic achievement. They are considered pivot economic regions of China that develop industry, introduce new technologies and bring in foreign investment.

However, some critics claim that the role of the SEZ in China's overall development have been overstated and their negative aspects ignored. An article by Shankar Gopalakrishnan appearing in the Economic and Political Weekly cites the loss of agricultural land, property speculation as well as labor abuse as the main reasons for concern regarding SEZs.

In China, real estate is classified as either rural or urban, and only urban land use rights could be transferred to private parties. Gopalakrishnan writes that because rural land could only be sold to the state, which could then designate it as urban land and sell development rights on it, a speculative market was born.

Shenzhen was one of the first special economic zones set up in the 1980s. (Image: China News Service)

The speculation led to the decrease of agricultural land in China with an estimated five million hectares transferred to industry between 1986 and 1995, the same article said. The situation was so bad that the central government put a stop to land use conversion in in 1997.

Migrant workers came in droves to work in the mushrooming industries in the SEZ. But this led to labor abuse, with a substantial number of workers not receiving their salaries or receiving less than minimum wage.

The new tax law: a death knell for SEZs?

In March this year, the National People's Congress passed the corporate tax law, which strikes at the heart of one of the basic privileges that SEZs have.

Foreign companies that invest in SEZs are given special tax incentives during their start-up period. The "tax clock" starts ticking only on the first year that the company turns a profit. Typically, for the first and second year after the company makes a profit, it doesn't pay any taxes and enjoys preferential rates for the next couple of years.

"The new corporate income tax law does suppress the difference between domestic and foreign enterprises because domestic enterprises have a different set of tax laws applicable to them," Serge G Fafalen, managing director of SG Fafalen & Co., a law firm that is registered in Hong Kong and Geneva, Switzerland, explains.

"As a consequence, any kind of advantages, or tax holidays that were applicable to the foreign enterprises are going to be suppressed. There is a provisionary period set forth before the changes will take effect, but at the end of the day, what the Chinese government wants is one tax regime applicable to any enterprise, whether domestic or foreign."

Fafalen says that the new tax rate proposed, at 25 percent, is still reasonable, although the fact that a company has to pay higher taxes would make its investment more expensive. The new tax law, which will take effect on January 1, 2008, is in compliance with World Trade Organization regulations.

"The old tax laws were not compliant with the WTO requirements. The government could not discriminate between domestic and foreign enterprises. The new tax law had to be passed because China wanted to be WTO-compliant."

"The SEZs could be affected because over a period of time, companies who invest there would no longer get tax holidays. And if companies lose their tax holidays, this will impact the cost of their production."

How the new tax law, coupled with the fact that the special privileges granted to SEZs are also now granted to other regions will affect the special economic zones remains to be seen.