Free zones are geographically defined areas in which companies are subject to special rules that differ from those in the rest of the country. Investors are often granted tax breaks, duty exemptions, and other financial incentives. In addition, they often benefit from simplified administrative procedures and high-quality infrastructure.
Free zones, or special economic zones (SEZs) as they are referred to in some jurisdictions, are a widely used economic policy instrument, especially in emerging and developing countries, aiming at creating attractive investment conditions for companies and thus compensating for weaknesses in the national business environment. They usually aim to attract foreign direct investment, increase and diversify exports and create jobs. Additionally, governments expect the domestic economy to benefit from knowledge and technology spillovers in the long run.
Free Zones in Latin America
According to the Inter-American Development Bank (IADB), the disruption in the global value chains due to covid and the war in Ukraine (not to mention the US/China tension) could mean a $70 billion USD investment opportunity for Latin America.
Latin America has become a strategic place for foreign investors since it has shown a diversification of its industries and an internationalization of its strategies. Furthermore, the geographical position of the continent is seen as an advantage since it facilitates value-added logistics operations and nearshore manufacturing between countries and has rapid access to natural resources and materials.
Many Latin American countries have developed free trade zones that have helped to boost foreign trade and attract investors and companies by simplifying government restrictions. These free zones have proven to be GDP multipliers.
What Are the Objectives of Free Zones?
- Generate and create employment
- Capture new capital investment
- Develop highly productive and competitive industrial processes
- Attract new (and better-paying) industries
- Promote the generation of economies of scale
- Generate integration into global supply chains
Do Free Zones Work?
Criticism of free zones tends to focus on their operation as self-contained ecosystems within the local economy, where incentives exclusively target trade flows between SEZ firms and the international market (e.g., import/export tax incentives).
Countries such as Colombia, Dominican Republic, Panama, and Costa Rica have all seen net beneficial effects directly related to the development of free trade zones and the industries that they have attracted. These benefits range from higher wages, knowledge transfer, and internal economic linkages.
There are around 630 free zones in Latin America that generate around 984,812 direct jobs, and up to three times more indirectly. Approximately 10,738 companies are located in free zones in Latin America. In addition, in 2019 alone they accounted for $38 billion USD in exports.
For every dollar that the state does not collect in taxes in the free zones, $6.2 USD is generated in Costa Rica, $3 USD in Colombia, $6 USD in El Salvador, and $5 USD in the Dominican Republic. This means more purchasing power, more credits, more investment, generation of more jobs, and more money for the economy.
The average rate of profit in free economic zones in Latin America is 25%-30%. The payback period of capital investments in zones is 2-3 times shorter than in regular economic practice. It is considered normal when the invested funds pay off after 3-3.5 years. In many developing countries, 30%-80% of all foreign investments enter their economy through free economic zones.
Barriers to investment and an uncompetitive incentive structure can limit the success of free zones. The incentives offered should be designed in accordance with the national business environment, sectors of focus, tax system, and regulation. The incentives already offered by nearshore rivals should also be strongly considered.
How Free Zones Are Creating Economic Benefits in Latin America
The government-sponsored study, “Impact of the Free Zone Regime in Costa Rica, 2014-2018,” revealed that — for every $1 USD of tax not collected by the country — the regime generated $2.5 USD of social benefits for Costa Rican citizens. In absolute numbers, it means a contribution of $4.7 billion, which represents 7.9% of the gross domestic product (GDP).
“In a complex national and international environment, the study showed that, in 2018, 55% of the formal employment created in private companies was generated through companies that operate under the Free Zone Regulations,” according to CINDE (Costa Rica’s investment promotion agency).
The return on investment in the free zones has been significant for the Dominican Republic. It is also estimated that companies that participate in the free zones have an economic impact that is six times higher than the incentives extended to them. For every $100 RD granted to corporations in incentives, the free zones in turn provide $620 RD to the national economy, with a net benefit to the Dominican economy of $41.7 billion RD.
With 124 free zones in operation, Colombia concentrates 25% of the 400 in Latin America and ranks as the country with the largest number of industrial parks on the continent, according to data from the National Association of Entrepreneurs (ANDI). Free zones in the country employ approximately 152,000 persons directly.
According to Colombia’s National Administrative Department of Statistics (DANE), in the year 2022, total exports from free zones in Colombia reached $2.7 billion USD. The largest sectors accounting for free zone exports were: Industrial (55%), Services (32%), with BPO (accounting for 19% of all services), and Agribusiness (13%).
The United States was the main trading partner of Colombia’s exports from free zones for a value of $910 million USD. The next largest trading partners were Puerto Rico ($247.5 million USD), the Netherlands ($214.1 million USD), Ecuador ($170.7 million USD), and Panama ($138.7 million USD).
Free Zones as Export Multipliers
The advantages for exporters in a free zone go beyond the tax scheme. The also incorporate the special tax and a customs regime laser-focused on foreign trade and develop industrial ecosystems of goods and services that have first-rate physical infrastructure and logistics, energy and telecommunications capacity, and monitoring systems and security. These competitive conditions are game changers for many export-oriented companies.
There is often a misconception that free zones only benefit large companies. However, small and medium enterprises (SMEs) often operate from free zones as well. These companies tend to be focused on export of goods and services. An SME that settles in a free zone can enjoy benefits such as unique rates that significantly reduce income tax and take advantage of multiple customs advantages in import matters with reduced tariffs. Logically, proper and comprehensive tax, customs, and financial planning will allow a company to diagnose how feasible it is for SMEs to settle in a free trade zone.
On-site customs supervision may result in lower security and insurance costs. In many jurisdictions, duty payable on free zone merchandise does not need to be included in the calculation of insurable value, again lowering insurance costs. Reduced transportation costs may also result from streamlined logistics.
According to the business magazine LatinPyme, Colombian free zones feature a business ecosystem that helps small companies be much more competitive, improving their net margin by 22.5%-39%. This added to the constant innovation that opens doors and possibilities and allows the companies to have customs services and logistics onsite thus permitting them to focus on the client and be more disruptive.
Latin America: A Home for “Friendshoring”
The current political climate between China and the United States, along with other global concerns and supply chain factors, align to make Latin America and the Caribbean the most logical choice for North American companies to set up offshoring operations. The same goes for companies from Europe and Asia looking to move manufacturing closer to the North American and Latin American market.
These realities and free zones also provide Latin American companies with tangible advantages for accessing overseas markets. And, for the local economies, this can create higher-paying jobs and sustainable linkages.
While there have been outstanding successes by Latin American countries in building out free zones to attract investments and also incentivizing overseas companies to set up their own free zones, there remains far greater opportunities.
Some countries have not prepared their tax incentives and logistics ecosystem to be competitive with their neighbors. They have not created specialized training for personnel according to their sectors of focus and, most importantly, they have not focused on a few main sectors and implemented marketing plans to target companies in those sectors via their national investment promotion agencies in charge of attracting foreign investment.
The next few years will see more countries jockeying for investors, operators, and developers in free zones. Success will depend on location, logistics, port facilities, government support, tax incentives, availability and cost of human talent and transparent and sustainable government policies.
Nicholas Sunderland first posted this article on Linkedin. It has been republished here with permission.