The Evolution of Special Economic Zones

Special economic zones (SEZs) are areas where some laws which apply to the rest of the country do not apply. The first modern SEZ is generally considered to be Shannon, Ireland, created in 1959. As plane technology improved, trans-Atlantic flights no longer needed to stop at the Shannon airport. To ensure the continued vitality of the airport as well as the town, Ireland lowered taxes and reduced tariffs in Shannon.

Over the next  two decades the growth in SEZs was slow. The next major step in the evolution of SEZs was China. In 1980, China created four SEZs, Shenzhen being the most prominent. Chinese SEZs were similar to Shannon on many margins. They were created primarily to attract foreign direct investment to areas which otherwise would not have received it.

That being said, Chinese SEZs were also substantially different. The primary difference is they were not set up as a tax haven to attract corporate headquarters. Instead, Chinese SEZs were created to attract factories. Rather than targeting a small, highly skilled workforce, Chinese SEZs wanted to create jobs for a large, unskilled workforce.

The result has been an astounding success. The first year of the existence of the SEZ, Shenzhen attracted over 50% of all foreign direct investment in all of China. Over the long run, Shenzhen grew from a fishing village of 30,000 people to a booming metropolis of 16 million.

China recognized the success of their SEZs, copying them throughout the country. By 2005, there were 210 national development zones and 1,346 provincial development zones. Chinese SEZs have played a major role in China’s economic growth and lifting hundreds of millions of people out of poverty.

The creation of the Dubai International Financial Centre (DIFC) in 2004 was the next evolutionary phase of SEZs. Traditionally SEZs have simply cut around the edges of the laws of a host country. A typical SEZ will lower offer lower taxes, expedited customs, and maybe simplified business registration. Dubai changed that. Instead of asking what to cut, they asked what to build.

The result is that in just over 10 years the DIFC has become one of the leading financial centers in the world. It accomplished this by importing a financial legal system everyone trusted. It hired a British judge, a common law is generally considered better for development.

Unfortunately, since the DIFC the evolution of SEZs has largely stalled. Everyone learned the wrong lesson from Dubai. They saw the magnificent architecture and believed the architecture was the cause of Dubai’s success, rather than the consequence. I do not know of any other financial center which has imported common law.

The evidence supporting SEZs is also mixed. While China was a great success, there are many other attempts which have failed. The failures can relate to infrastructure, governance, or simply because an SEZ was a handout to a politically connected business.

More importantly, the low hanging SEZ fruit has already been picked. There were only a few countries where the marginal changes that SEZs bring were enough to jumpstart growth. In most countries, governance problems are deep seated, so that simply lowering taxes or expedited customs will have a limited effect.

Luckily, trends still point in a positive direction. SEZs are being rethought. The next stage in SEZs is the importation or creation of new legal systems. Instead of cutting away at the edges of a legal system, start from a blank slate. These more radical changes can create the framework necessary for sustained economic growth.

In practice this means using common law. Dubai imported common law for their DIFC. The next step is to use common law for a new town or city. Of course, changes will need to be made on the margin to ensure the legal system accords with the norms of the local population. However, common law will remain the base and different SEZs will simply make different alterations to it.

The most prominent voice advocating for the importation of successful legal systems is Paul Romer, now the Chief Economist at the World Bank. He advocated for Charter Cities. A Charter City would be built in a developing country, and administered by a developed country. This would allow the importation of good institutions to areas which currently lack them. Instead of the Band-Aid approach of SEZs, Charter Cities would import environments known to be conducive to growth.

A project in a similar vein is the zonas de empleo y desarollo economico (ZEDEs) in Honduras. ZEDEs create a blank slate which can import a successful legal system to accelerate economic growth. Unfortunately, though the ZEDE legislation passed, the project has been stalled for several years.

There has been a marked increase of interest in ensuring new cities have good legal systems. If current trends continue, I expect to see the first successful free city in ten years.

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