Free zones are geographic government-designated zones where business, trade, and tax laws differ from the rest of the country. Known also as free economic zones, special economic zones, or free ports, depending on their structure and purpose, they provide incentives such as abated taxes and fewer regulations to encourage overseas companies to set up local operations.
Any forgone tax and tariff revenue is, in theory, offset by presumed economic benefits, including increased employment, exports, and greater foreign direct investment. Anticipation of such benefits has led to the dramatic expansion of free zones around the world. As of 2015 there were an estimated 5,000 free zones in well over 100 countries, more than five times the number of zones in 1997.
This growth begs an obvious question: are free zones worth the cost in sacrificed government revenues? Less obvious but equally important to questions of short-term return on investment (ROI) are those focused on long-run impact, and on the role free zones can play in innovation.
SRI’s Center for Innovation Strategy and Policy works with regions around the world to improve the effectiveness of regional innovation ecosystems, and also provides strategic guidance to free zones wishing to accelerate their impact on innovation. Recently, SRI was invited to share its insight on free zone evaluation at the annual World Free Zone Organization conference, and I was honored to present that perspective. In my talk I emphasized the significant and still largely untapped opportunity for free zones to accelerate regional innovation.
SRI’s work on regional innovation ecosystems focuses on six key pillars of regional ecosystem development:
- Talent: the mix of business, entrepreneurship, and technical skills, experience, and attitudes found in the workforce
- Business environment: the characteristics of infrastructure, geography, market demographics, and other characteristics that provide competitive advantage
- Idea generation: the volume, quality, and focus of business-relevant ideas generated
- Access to markets: the customers accessible to provide test beds, co-development opportunities, early revenue, and long-term customer base
- Risk capital: the quantity and quality of equity capital and other financing available for high-risk ventures
- Innovation networks: the networks and hubs that help connect area ideas, talent, investors, and mentorship to markets and each other
Unfortunately, traditional approaches to assessing the impact of free zones look too narrowly at cross-sectional economic impacts: direct impacts such as the amount of foreign investment won and jobs created; the indirect economic benefit to local firms outside the free zone as a result of the business they garner from free zone firms; and what are known as induced effects, the effects of consumer spending by free zone employees.
This “fenced-in view” focuses almost entirely on how factor prices such as wages and raw materials costs affect free zone value, and leads to an unsustainable winner-takes-all environment in which price is the only basis for competition and the “cheapest” free zones always wins.
Free zones require broader, innovation-based strategies if they are to survive for the long run. As I highlighted at the World Free Zone Organization conference, free zones need to take greater advantage of their unique position within local economies and act as platforms for innovation-focused investment and activity.
Free zones already provide a mechanism by which embedded technology and critical knowhow is transferred into regions in the form of capital equipment and well-trained employees. By providing innovation support services – such as management mentorship, intellectual property assistance, and networking – along with traditional business services they already provide, free zones can attract a wider set companies, including startups and other technology-focused small firms.
Bolstered by well-developed innovation programs, such tech-based firms can grow to sufficient numbers that they attract the attention of venture funding, drawn to the concentration of entrepreneurial activity.
The arrival of venture funding in turn will attract more startups, kick-starting a virtuous circle of innovation that can, over time, transform free zones into regional centers for innovation. As free zone tech companies expand their networks and build wider connections to other firms in the supply chains in which they participate, the impact of free zones on innovation will only grow and expand, ultimately leading to the development of innovation corridors and to sustainable innovation-based economic development.