When Regional Policies Fail: An Evaluation of Indonesia’s Integrated Economic Development Zones

In developing countries, manufacturing firms are often characterized by small scale and persistently low growth. Such firms are constrained by restricted access to markets, capital and technologies, as well as by unfavorable investment climates. To spur industrial growth, many developing countries have established special economic zones, a particular place-based policy that provides tax incentives and reduced regulatory burdens for firms who locate in specific places.

A new working paper by Samuel Bazzi and colleagues investigates the short- and long-term effects of a large place-based intervention in Indonesia known as the Integrated Economic Development Zone (Kawasan Pengembangan Ekonomui Terpadu, or KAPET) program. This program provided substantial tax-breaks for firms that locate in certain districts in the outer islands of Indonesia, a country with large regional differences in per-capita income and a history of policies to promote inclusive growth.

Main findings:

• KAPET districts experienced no better development outcomes, and in some cases fared even worse than their non-treated counterparts. Firms in KAPET districts paid lower taxes, but these tax reductions neither encouraged greater firm entry, increased migration nor raised local measures of output or welfare. 
• Overall, the KAPET program does not appear to have achieved the intended outcome of promoting growth in lagging regions. 
• There are many possible reasons that the KAPET program failed: the fact that it started around the time of the 1998 Asian Financial Crisis and its subsequent political upheaval meant firms may not have been interested in making use of the incentives, given the political uncertainty and the volatile exchange-rate environment, at least initially. Moreover, because the program operated at the district level during a period of “big bang” decentralization, it may have operated differently across treated districts, leading to large variation in project performance. 

Ultimately, more theoretical and empirical research is needed on the effectiveness of place-based policies in developing countries, especially to determine whether such policies may have different justifications, either from the perspective of reducing poverty for immobile workers or by removing capital constraints in poorer regions. This case study on the effects of the KAPET program suggests that such policies face an uphill battle, but it is by no means definitive, and more examples need rigorous assessment.