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Article Excerpt
Abstract. Not only a large number of developing countries but also transition economies have established free economic zones (FEZs) with the aim of attracting foreign capital by providing tax incentives, creating employment opportunities, and promoting exports and regional development. Tax investment promotion schemes include profit tax exemption, free or accelerated depreciation, investment tax allowance, subsidy for investment costs, etc., the effects of which on firms' investment decisions can be compared based on the net present value model. This study suggests that even a low corporate tax rate combined with generous depreciation rules does not provide incentives for investors when the inflation rate is high. A case study on Najin-Sonbong FEZ in North Korea delivers a wide range of more crucial economic and political reasons why such a development project can fail, although tax concessions offered there are more favourable than those in China and other Asian nations.
Key words: free economic zone, investment decision, net present value, tax concessions
1. Introduction
The establishment of a free economic zone (FEZ) is arguably one of the most significant institutional innovations that has spread throughout the world economy in recent years. (1) The FEZ as a territorial enclave in which foreign firms (in many cases also in co-operation with indigenous companies) benefit from generous incentives and privileges and thereby produce industrial goods mainly for export (Grubel, 1983; Schweinberger, 2003). FEZs have found popularity in developing countries, notably in the newly industrialised countries in Asia. The diffusion of this development concept as a growth-oriented policy instrument in developing countries is likely to continue in the near future. In recent years, however, this measure has also been adopted in the former centrally planned economies of Eastern Europe as an instrument of stimulating economic and structural transformation (Litwack and Qian, 1998). The first application of this type of development measure began with the creation of special economic zones (SEZs) in China. Nowadays the FEZ concept is increasingly gaining importance in other transformation countries in Europe including the former USSR, Poland, Hungary and Bulgaria as well as in Asian countries such as Vietnam and North Korea (UNCTC, 1990, 1991).
One of the crucial characteristics of the FEZ is the provision of generous tax investment promotion schemes solely permitted in this enclave, although it is often asserted that tax incentives alone have not been successful in attracting foreign direct investment (FDI) (OECD, 1995; Clark, 2000). Such measures include: (a) profit tax exemption (2) or reduction, (b) free or accelerated depreciation, (c) investment tax allowance, (d) subsidy for investment costs, etc. According to Easson (1996/97), export-oriented investment is generally much more sensitive to (corporate) taxation and likely to be influenced by incentives than is investment aimed at the domestic market, since the tax is in effect exported as a part of the cost of the product. A negative implication of such incentive schemes is the erosion of the tax base (Zee et al., 2002).
Investors generally tend to adopt a two-stage process when evaluating FDI locations. In the first stage they examine countries and regions based on their fundamental determinants like market size, access to raw materials, availability of skilled labour, etc. (Witthans, 1984). Only those areas that satisfy these criteria go on to the next stage of evaluation where tax rates, grants and other incentives become important. However, government can quickly and easily change the range and extent of tax incentives they offer, whereas changing the other location factors mentioned above may be difficult and time-consuming, or even beyond government control (UNCTAD, 2000). (3)
In this study the incentive effects of various tax concessions on firms' investment decisions can be compared on the basis of the net present value model. (4) Without taxation, net present value (NPV) is equal to present value of future gross return, discounted at an appropriate interest rate less the cost of investment. An investment project is therefore considered to be profitable when NPV is positive. After introducing corporate income tax, the present value of the asset generated from an investment amounts to the sum of present value of net return (gross return less taxes) and tax savings led by an incentive depreciation provision. If the investment is self-financed, the interest rate directly corresponds to the investor's opportunity cost. Under the assumption of a perfect competitive market structure, there is only one interest rate in the financial market.
In addition, anticipated effects of inflation on firms' investment decisions are examined in the context of corporate income taxation. The central issue is that the so-called historical cost accounting method, which is applied in practice when calculating the (corporate or income) tax base, causes fictitious profits in inflationary phases that are also subject to tax. This type of increased tax burden is generally referred to as inflation loss (Kay, 1977; Feldstein, 1979; Gonedes, 1984; King and Fullerton, 1984; OECD, 2001; Devereux et al., 2002). (5) Therefore, in periods with inflation generous tax concession measures do not adequately promote private investment in the FEZ, as intended, but only (or partly) compensate the losses caused by inflation.
In North Korea the concept of setting-up the Najin-Sonbong FEZ in 1991 was largely taken from that of the Chinese SEZs, which have been successfully playing the role of growth pole and the 'window and bridge' for economic development and transformation in China. By contrast, however, the recent North Korean experience with Najin-Sonbong has unfortunately been disappointing, despite the fact that tax advantages offered in this FEZ are quite generous. "North Korean sources claimed that as of March 1999, contracts for 111 projects had been signed, with foreign investment in these projects amounting to US$750.77 million, of which US$140 million had already been invested. However, according to statistics released by the United Nations Development Program (UNDP), which supported the Najin-Sonbong initiative, also known as the Tumen River Development Program, the FDI between 1992 and 1998 totalled only about US$88 million, which was mainly committed to the communications, hotel, and real estate sectors" (Lim and Chung, 2004, p. 52). Apart from some crucial economic and infrastructure impediments which hinder large-scale FDIs in North Korea, this study also suggests that the political instability in the country and the inflexibility of the communist regime that fears the introduction of a market system have been badly damaging the development potentials and opportunities of the Najin-Sonbong FEZ (see also Noland, 2003).
2. Free economic zones as an instrument of economic growth and transformation
It is well acknowledged that the introduction of market mechanisms and the modernisation of economic structure in developing and transformation countries can be more rapidly and efficiently carried out through the comprehensive integration into the international economic and business system. The most typical and traditional ways of establishing international economic co-operation are trade and FDI, which are also closely associated with the flows of technology and management techniques as well as the access to international markets. In general, major objectives of FEZs in emerging countries appear to be the creation of (a) 'islands of competitiveness' in an economy which is not yet ready to submit itself fully to (market-oriented) international competition and (b) transmitters of the advantages of market economic system to the domestic economy to make the entire nation more prosperous and competitive (UNCTC, 1991, p. 345).
Over the last two decades, many developing (as well as developed) countries have established FEZs with the aim of attracting foreign capital through the provision of tax incentives, promoting exports, creating employment opportunities and promoting regional development (UNCTC, 1990; Chen, 1993; Tuppen, 1993). Regarding the general effects of tax incentives (and other public policy measures such as easing of foreign currency regulations, decentralisation of development policy making, etc.) on firms' location in the FEZ and other types of enterprise zones, Bartik (1991) and Ge (1995) argue that there are positive relationships between the presence of such incentives and increased economic activity. (6) Particularly tax incentives in areas of high unemployment are more likely to be cost-effective and progressive (Young and Miyagiwa, 1987), although this empirical finding is questioned by Fisher and Peters (1998) and Gross and Phillips (1999). (7) In addition, as Papke (1992) suggests, "incentive may affect factor prices, and incentives that lower the price of capital goods have both an output effect (whereby production and employment increase because costs are lowered) and a substitution effect (whereby capital is substituted for labour). If the substitution effect is stronger, a capital intensive could reduce employment" (Fisher and Peters, 1997, p. 125).
Unlike a larger number of references including Devereux and Chen (1995) and Schweinberger (2003) highlighting the desirability of SEZs for the stimulation of foreign capital inflows, some economists like Hamada (1974), Rodriguez (1976) and Hamilton and Svensson (1982) argue in the Heckscher-Ohlin framework that foreign investment attracted in SEZs can have an effect of lowering welfare. "The root cause of possible immiserization effects in developing countries ... is that foreign investment in the [SEZs] entails movements of mobile factors between the domestic and [SEZs]. The latter may imply that the outputs of the industries which are overproduced in the original equilibrium (with economy-wide tariffs) rise even more [and consequently reduce] the value of output of the whole economy at world market prices" (Schweinberger, 2003, p. 620). When the trade of intermediate goods are considered in the analysis, a...
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