Report No. 27357-CH Chile Zonas Extremas Policies and Beyond An Assessment of Costs and Impact with Recommendations of Avenues for Policy Reform October 1, 2005 Poverty Reduction and Economic Management Unit Latin America and the Caribbean Document of the World Bank MAINABBREVIATIONS AND ACRONYMS CAS Country Assistance Strategy CASEN National Socio-Economic Survey CEPAL Economic Commission for Latin America and the Caribbean (ECLAC) (Comisidn Econdmicapara Ame'rica Latina y el Caribe) CIEPLAN (Corporaci6nde Investigaciones Economicaspara Latinoamerica) CIDESE Inter-Ministerial Committee for Zonas Extremas and Special Territories Policies csos Civil Society Organizations CORFO Industrial Development Corporation (Corporacih de Foment0 de la Produccih) DL Legislative Decree (Decreto Legislativo) DFL Decree equivalent to a Law (Decreto con Fuerza de Ley ) EFTA European Free Trade Association EZ Enterprize Zone EPZ Export Processing Zones EU European Union FNDA National Regional Development FundFondo Nacional de Desarrollo Regional) FTAs Free Trade Agreements FTAA Free Trade Area of the Americas FONDEMA Magallanes Development Fund(Fondo de Desarrollo de Magallanes) GNP Gross National Product GDP Gross Domestic Product IDB Inter-American Development Bank IMF International Monetary Fund INE National Statistical Institute (Instituto Nacional de Estadistica) ILO International Labor Organization (Organizacih Internacional del Trabajo) IRAL Local Assignment Regional Investment ISAR Regional Assignment Sectoral Investment Program IT Information Technology JICA Japan International Cooperation Agency LOCGAR Regional Government and Administration Law (Ley Orginica Constitucional de Gobierno y Administracih Regional) MERCOSUR Southern Common Market (Mercado Comdn del Con0 Sur)) MR Metropolitan Region MIDEPLAN Ministry of Planning NAFTA North America Free Trade Agreement NGOs Non-Governmental Organizations ODEPLAN National Development Policy Organization (Organizacih de Planificacibn Econ6mica Global) OECD Organization of Economic Co-operation and Development SEREMI (Servicio Regional de 10s Ministerios) SUBDERE Undersecretary for Regional Development and Administration (Subsecretaria de Desarrollo Regional y Administrativo) PAT Regional Policy Grant UNDP United Nations Development Program UNAP National University of Patinacota (Universidad Nacional de Patinacota) UTA Tarapaca University (Universidad de Tarapaca) UK United Kingdom USA United States of America UTM Monthly Tax Units 1UTM= 29.379 Peso, December 2003 (Unidad Tributaria Mensual) VAT Value Added Tax (Impuesto a1Valor Agregado, IVA) ZE Extreme Zones (Zonas Extremas) ZOFRI Free Trade Zone, Iquique (Zona Franca Iquique) ZOTAC-ILO Free Trade Zone, Tacna - no (Zona Franca de Tacna) TABLE OF CONTENTS 2.IDENTIFICATIONAND CHARACTERIZATIONOFTHEZES INCHILE................................................................ 1.INTRODUCTION ....................................................................................................................................................... i ii 3.THE INSTRUMENTSAND COSTS OF ZEPOLICIES INCHILE............................................................................. A.FISCAL vi ............................................................................... V I 4.EVALUATIONOFZEPOLICIESINCHILE .......................................................................................................... B.ZEALLOCATIONS PUBLICEXPENDITURE INCENTIVESFORPRIVATEENTERPRISES OF TRANSFERS AND PUBLICPROGRAMS ......................... IX xii 5.PROPOSALSTO IMPROVETHEREGIONAL DEVELOPMENT 6.SUMMARY OFEVIDENCE POLICIESINCHILE ........................................ xvii AND RECOMMENDATIONS ................................................................................... xxii CHAPTER 1. INTRODUCTIONAND TERMS OFREFERENCE............................................................. 1 THECONCEPTOFZONASEXTREMAS ..................................................................................................................... 1 THETERMSOFREFERENCEFORASSESSING AND REFORMULATING POLICIES ................................ ZE 3 OUTLINEOFTHESTUDY........................................................................................................................................... 4 NEWPOLICY THRESHOLDS CHILE.................................................................................................................. FOR 4 GOVERNANCE (DEMOCRACY AND DECENTRALIZATION) ........................................................................ 4 OPENNESS AND INTERNATIONALIZATION ............................................................................................... 5 SOCIAL POLICYAND HUMAN CAPITAL ................................................................................................... 6 CHAPTER 2. CHARACTERISTICS OFTHE ZONAS EXTREMAS ......................................................... 7 ZES ININTERREGIONALCONTEXT......................................................................................................................... 7 Geography ............................................................................................................................................... 8 Demography ............................................................................................................................................ 8 CHAPTER 3. THEINSTRUMENTS AND COSTS OFZONAS EXTREMAS POLICIES...................... 10 FISCALINCENTIVES FORPRIVATEENTERPRISES ............................................................................................... 10 Free-Trade-Zone Incentives .................................................................................................................. 11 Wage Subsidies (DL889) ..................................................................................................................... 15 16 Investment Subsidies (DFL 15)............................................................................................................. Investment Tax Credits ......................................................................................................................... 17 Sales Subsidies ...................................................................................................................................... 18 PREFERENTIALZEALLOCATIONS PUBLICEXPENDITURE OF TRANSFERS ..................................................... 18 Regional Investment Financing............................................................................................................. 19 Current Social Expenditures.................................................................................................................. 19 Cost Estimates....................................................................................................................................... 19 21 Miscellaneous Expenditures.................................................................................................................. Civil Servants andthe Wage Bonus...................................................................................................... 22 THEAGGREGATE COSTSOFZEPOLICIES ........................................................................................................... 23 CHAPTER 4. EVALUATIONOFZONAS EXTREMAS POLICIES ........................................................ 25 DIFFERENCES AMONG THE ZES ............................................................................................................................ 25 Social Indicators.................................................................................................................................... 25 Incomes ................................................................................................................................................. 25 Public Spending .................................................................................................................................... 25 Exports .................................................................................................................................................. 26 Recapitulation ....................................................................................................................................... 26 StructuraVEconomic Differences .......................................................................................................... Cost of LivingDifferences.................................................................................................................... 27 27 PERFORMANCEEVALUATION CRITERIA IMPACT OFCURRENTINSTRUMENTSONRELEVANT ECONOMIC AND SOCIAL INDICATORS . ............................................................................................................. 28 PERFORMANCEEVALUATIONMETHOD ................................................................................................................ 29 HAVE ZEPOLICYOBJECTIVESBEENACHIEVED?..................................................................................... 29 Population Growth ................................................................................................................................. THE 30 Free-Trade Zones: Region IExperience ............................................................................................... 31 Socio-Economic Indicators ................................................................................................................... 33 HowEFFECTIVE HAVE Region I................................................................................................................................................. 38 THEZEPOLICIES BEEN? .............................................................................................. 37 Regions XI and XI1............................................................................................................................... 40 Shift-Share Analysis.............................................................................................................................. 39 CONCLUSION.............................................................................................................................................................. 43 AVENUES FORPOLICY REFORM........................................................................................................... 45 CHAPTER 5. IMPROVING THE SCOPE OF REGIONALIZEDPOLICIES.ALTERNATIVE INTRODUCTION: REMAININGPOLICY QUESTIONS .............................................................................................. 45 IMPROVING CURRENTINCENTIVEINSTRUMENTS ............................................................................................... 45 A reconsideration of fiscal subsidies and public policy measures ........................................................ 45 Wage subsidy ........................................................................................................................................ Investmenttax credit............................................................................................................................. 50 53 Development Fund(Fondo de Foment0y Desarrollo) and investment subsidy ................................... 58 TARGETED, DIFFERENTIATEDPOLICIES FORTHE NORTH THE SOUTH: FROM"ZONAS AND EXTREMAS""ZONAS ESTRAT~GICAS" TO ..................................................................................................... 58 The Needfor Reform and Basic Policy Options................................................................................... 58 Developing an economic growth strategy for the North. Toward an Enterprise Gateway in Region I................................................................................................................................................. 59 61 PREPARINGTHE GROUNDFOR LONG-TERMECONOMIC GROWTHAND PROSPERITY..................................... Enhancing regional policies for the South ............................................................................................ 63 Anti-poverty focused, growth-oriented regional policies...................................................................... 63 Strengthening public governance inthe regions ................................................................................... 66 CHAPTER 6. SUMMARY OFFINDINGS AND RECOMMENDATIONS.............................................. 67 Annexes A. STATISTICAL ANNEX........................................................................................................................................ 71 B REGIONXIAYSEN c. . . ............................................................................................................................................. 73 D. INTERNATIONALEXPERIENCES: CAPITAL vs EMPLOYMENT SUBSIDY ............................................................................................................ 78 ENTERPRISE ZONES AND EXPORT PROCESSINGZONES ...................... 78 E. CONSTITUTIONALAND LEGISLATIVE INITIATIVES THAT MIGHTCHANGETHE SCOPEAND PURPOSESOFREGIONALGOVERNMENTSAND REGIONALDEVELOPMENTPOLICIES............................... 80 F WORK PROCEDURES-LISTOF OFFICIALSMET, AND BANKTEAMMEMBERS........................................... . 83 BIBLIOGRAPHY.......................................................................................................................................... 87 Tables Table 1. Characterization of the ZEs inthe National Context ............................................................ iv Table 2. Composition of GDP. 2000 _. ............................................................................................... V Table 3. Summary of Current Incentives ....................................................................................... VII Table 4. Characterization of the Incentives inEffect ..................................................................... vi11 Table 5. Total Cost of ZE policies, 2001 ........................................................................................ .................................. IX X Table 8. PopulationGrowth, 1970-2002....................................................................................... Table 7. Differential in Distribution of Civil Servantsand their Wages by Region, 2002 ..................XI Table 6. Preferential Assignment of Transfers and Public Programs to the ZEs XIII Table 9. Operations of the Iquique Free Trade Zone, 1976-2002.................................................... Table 10. Socioeconomic Indicators, 1990-1998 ............................................................................. XIV XV Table 11. Structural and Marginal Regional Growth, Employment andProduct 1986-2001 .............XVII Table 1.1Old Legal Definitions of ExtremeZones ............................................................................ 2 Table 1.2 Terms of Reference........................................................................................................... 3 Table 2.1 The Zonas Extremas inInterregionalContext ..................................................................... 9 Table 3.1 Summary of ExistingBenefits by Province/ Region ......................................................... 11 Table 3.3 The Aggregate Costs of ZEs Policies, by Region, 2001 in US$ millions ............................. Table 3.2 Zona Franca Iquique,ZOFRI........................................................................................... 13 15 Table 3.4 Wage Subsidy DFL 889 (US$ millions) ........................................................................... 16 Table 3.5 Key Featuresof ZEs Policy Instruments ........................................................................... 18 Table 3.6 Preferential Public Expenditures on ZEs 2001 .................................................................. 20 Table 3.7 Cost of Living Index, 2001 .............................................................................................. 21 Table 3.8 Number of Civil Servantsper Capita by Region, 2002....................................................... 21 Table 3.9 Civil ServantsWage Bonus by Region, 2002. ................................................................... 22 Table 4.1 Composition of GDP.for ZEs, 2000 ................................................................................. 28 Table 4.2 ZE PopulationGrowth .................................................................................................... 30 Table 4.3 RegionalPopulationGrowth 1970 - 2002 ......................................................................... 34 Table 4.4 RegionalPer Capita GDP 1990 -1998. (annual -- thousands of pesos) ............................... 34 Table 4.5 Social Economic Indicators 1990-1998 ( percent)............................................................ 35 Table 4.6 Public Social and Investment Expenditures (US $ per capita)............................................. 36 Table 4.7 Unemployment 1990-1998 .............................................................................................. 37 Table 4.8 Shift Share Analysis of Employment and Output Changes 1986-2001................................ 40 Table 4.9 Comparison of EUand Chilean Assistance to Lagging Regions" ....................................... 41 Table 5.1 Deadweight Spending andor Non-Additional Employment............................................... 52 55 Table 5.3 Composition of the Regional Economy (percent) .............................................................. Table 5.2 Value andEligibility of Major Investment Incentives inEUCountries, 1992...................... Table A.1Poverty Incidence .......................................................................................................... 71 62 Table A.2 (Monthly HouseholdAutonomous Average Income) ........................................................ 71 Table A.3 Competitiveness Index ................................................................................................... 72 Table A.4 RegionalDensity 72 Table AS Regional Populations, 2002 Census, in '000..................................................................... ........................................................................................................... 73 Table A.6 Populationof Most Important Cities within ZEs............................................................... 73 Table A.7. Advantages and Disadvantages of the Various Incentives..................................................... 78 Table A.8 Synthesis of proposed reforms to the ConstitutionalOrganic Law about Regional Government and Administration (LOCGAR) .................................................................. .81 Table A.9 Synthesis of proposed Constitutionalreforms on Regional Government and Administration82 Team - World Bank ..................................................................................................................... .86 Figures Figure 11-1Maps of Chile and South America ..................................................................................... 7 EXECUTIVE SUMMARY INTRODUCTION 1. Context. For political and administrative purposes, Chile is divided into 13 regions, which in turn are subdivided into 50 provinces encompassing 341 municipalities. The Metropolitan Region of Santiago includes the capital city and the remaining 12 regions are numbered correlatively from north to south. Within the latter, certain areas have historically been identified as Extreme Zones - Zonas Extremas (ZE)and qualified as such, have received special treatment in terms of public policies. Most of the exception instruments that currently benefit the ZE were created more than 20 years ago, and have followed an incremental dynamic not based on impact assessments. This has generated a wide range of benefits, some of doubtful effectiveness and efficiency, with significant fiscal costs, and with diverse objectives that are not necessarily consistent. In addition, Chile has experienced considerable change since these policies were established, altering the conditions that initially justified some o f them. Among the changes are greater decentralization, greater democratization --both at the national and local levels-- opening and internationalization of the economy, social progress and development of human capital. 2. Objectives of the Study. Within the context described above, the Government of Chile deems it necessary to evaluate, qualitatively and quantitatively, the exemption instruments that currently benefit the ZE. This, with the objective of reviewing modifications to-or elimination of-current instruments, as well as the implementation of new, more effective and efficient instruments. The intent i s to advance toward the development of guidelines for a comprehensive regional development policy for balanced, long-term and equitable growth both at the interregional level-encompassing all the regions-and at the population level-with emphasis on targeting public efforts to the poorer population. Inshort, the principal contributions of this study will be: i)to estimate the fiscal cost of the pro-ZE policies; ii)to evaluate the effectiveness and efficiency of current ZE policies; and iii)to propose guidelines for a comprehensive regional development policy. 3. To achieve the above, the study pursues the following specific objectives: a) characterize and discuss the qualification of ZEs; b) analyze the consistency of current public policies for the ZEs; c) scale the fiscal expenditure (subsidies) and tax-related (exemptions) that such policies imply; d) qualitatively evaluate their performance in terms of their declared objectives; e) quantitatively evaluate their performance in terms of their economic and social impact; f) determine their effectiveness and efficiency; g) identify the best practices and international instruments used to achieve similar objectives; and h) propose guidelines for the reformulation, elimination and creation of instruments. 4. Organization of the study. Inaddition to its introduction, the study is divided into five chapters. Chapter 2 identifies and describes the ZEs legally designated as such in Chile. Chapter 3 describes the different ZE policies currently in force, identifying their individual and aggregate costs. Chapter 4 identifies the indicators to evaluate the impact of ZE policies, i comparing the performance of the ZEs versus that of Chile as a whole, and analyzing the role of these policies based on the differences observed. Chapter 5 suggests reforms to the current exception instruments with a view to increasing their effectiveness and efficiency. Furthermore, it proposes guidelines for a regional development policy consistent with long- term balanced growth geared toward the reduction of poverty and sustained on the competitive advantages of each region. Finally, Chapter 6 summarizes the findings and proposes recommendations. IDENTIFICATIONAND CHARACTERIZATION OF THE ZES INCHILE 5. Identificationof the ZEs. Consonant with the different current laws, the ZEs inChile include: Region I(Tarapacd), and the province of Tocopilla in Region I1(Antofagasta) inthe north; Region XI (Ayskn), Region XI1 (Magallanes), and the provinces of Palena and ChiloC in Region X (Los Lagos) in the south and Easter Island, located in the Pacific Ocean, 4,500 Kmoff the north coast. For purposes of this study, the analysis focuses mainly on Regions I, XIandXII. Figure 1.Geopolitical Map of Chile Clearedby: World Bank Map Section 6. Conceptual justification of the ZEs. Factors influencing the definition of the ZEs have been geographical, historical, and geopolitical. In geographical terms, they are all far from the capital city inthe Metropolitan Region. However, it i s important to note that the ZEs in the northern part of the country are not in any way isolated from South America or the Asia-Pacific area. In historical and geopolitical terms, the ZEs were incorporated to Chile at the end of the 19th Century following diplomatic and military conflicts, with Peru and Bolivia in the north, and with Argentina in the south. Since their incorporation, the Chilean Government recognized the need to consolidate its sovereignty in these areas, its effective management, and the territorial integrity of the country. Although explicit strategies were not devised to achieve these objectives, it can be argued that the road selected inpractice has been that of promoting the economic development of the ZEs, improving the living conditions of their population, and strengthening the management of these territories. All this with the ultimate end of ensuring a national population of critical mass inthe ZEs, consistent with the geopolitical justification to support them. It i s precisely because of the influence of this justification that, to date, the policies favoring the ZEs have not been rigorously evaluated in terms of their cost-benefit ratio. 7. Characterization of the ZEs. Following i s a description of the ZEs, compared with the rest of the country with regard to: i)demographics; ii)income; iii)social indicators; iv) public spending; v) exports; vi) cost of living; and vii) productive structure. In general it i s observed that in comparison with the rest of the country, the ZEs have smaller populations, comprise large territories, are highly urban, have high production and income levels, good social indicators, andbenefit from highpublic spending. This i s a relatively enviable position. 8. Demographics. Regions XI and XI1 are the least populated and have the lowest population density in the country. Region Ii s the fourth least populated and has the fifth lowest density. In terms of urbanization levels, regions Iand XI1are well above the national average, while RegionXI i s slightly below the national average (columns 1-4, Table 1). 9. Income. Region XI1i s second with respect to GDP per inhabitant, Region Ii s fourth, while Region XI has a GDP smaller than the national average (column 5, Table 1). These relative positions change slightly when considering income per household (column 6, Table 1). 10. Social Indicators. In general, the ZEs show positive results in the social indicators (columns 7-10, Table l), especially Region XII, which i s better than the national average in all of them. However, Region Ii s below the national average with regard to incidence of poverty and housing deficit, while Region XI i s below in years o f schooling, housing deficits, and infant mortality. 11. Public Spending. Regions XI and XI1lead by wide margins the list relating to social spending and investments per inhabitant executed by the public sector. Region Ialso gets better treatment than the national average (columns 11-12, Table 1).As discussed in Chapter 3, these differences are essential parts of the preferential policies toward the ZEs. 111 ... c caP -.. E 0 eC ..f $a E fa y. .. C EC P X 'Ea H I C i sP L r 5b a I I x i xx H i i i , E i , I .-EM B L 12. Exports. The ZEs participation in exports i s only 9.2 percent. However, this figure more than doubles their participation in the national population (column 13, Table I).' The leading export products in Region Iare copper cathodes, iodine, and fish flour; in Region XI, salmon, trout, and gold; and inRegion XII, methanol. 13. Cost of living. There are differences in the cost of living in the different regions of Chile. However, these are only significant for the southern ZEs, partly explained by the cost of transportation of goods that can only reach them by air or sea. Indeed, in accordance with a study of the Ministry of Finance, the cost of livinginRegions XI and XI1i s 20 percent and 25 percent higher than that of the Metropolitan Region, respectively. In contrast, the cost of living in Regions Iand I1i s only 2 percent higher than that of the Metropolitan Region. This situation highlightsthe fact that only the southern ZEs (besides Easter Island) are isolated. 14. Productive Structure. While it i s emphasized that Regions I,XI and XI1 are more intensive in mining than the national average (copper in Region I,gold in region XI and methane in Region XII), each of them have a different productive structure. In Region Ithe main activities are trade and tourism, a reflection of the activity o f the Free Trade Zone at Iquique. In Region XI the main activities are agriculture-forestry and fishing (especially the latter). While inRegion XI1the main activity i s manufacturing (Table 2). Table 2. Compositionof GDP, 2000 Sector Chile Region I Region XI Region XI1 Livestock-Forestry and Fishing 8 4 21 9 Mining 11 18 16 21 Manufacturing 16 16 3 24 Electricity/Gas/Water 3 2 2 1 Construction 5 5 10 4 Trade and Tourism 19 29 11 13 Transportation and Communications 10 8 10 9 Financial Services 15 6 6 6 Other Services * 12 12 22 13 *Includes: real estate, personal services, and civil service. Source: National Instituteof Statistics. The 5.5 percent share of Region Idoes not include the importhe-export operations of the Free trade Zone. V THEINSTRUMENTSAND COSTSOFZE POLICIESINCHILE 15. Classification of Instruments. Current ZE policies in Chile include: i)fiscal incentives for private enterprises; and ii)preferential assignment of transfers and public programs. The first category i s aimed at decreasing operational costs and/or increasing profits of private enterprises to promote their establishment in the ZEs. The second category seeks to ensure that the provision of goods and public utilities, as well as social programs, inthe ZEs i s at least as good as in the rest of the country. It also promotes the establishment of enterprises and settlement of people inthe ZEs. A. FiscalIncentivesfor PrivateEnterprises 16. Listof currentincentives.Table 3 describes current fiscal incentives according to the area in which they are applicable and the year of implementation. Many incentives have been in place for more than 20 years, but at the same time there is a persistent creation of new instruments. Moreover, it should be noted that many incentives are not applicable to all the ZEs, but are specific to some of them. This and other characteristics are summarized inTable 4. 17. Free Trade Zones. There are six Free Trade Zones in Chile: a) commercial and industrial in Iquique; b) commercial and industrial in Punta Arenas; c) industrial in Arica; d) industrial-mining in Tocopilla; e) general in Navarino; and f) general in Tierra del Fuego. Two sources of fiscal costs emerge from these areas: i)smaller collection of VAT and customs duties on sale of imported products within the exempted region; and ii)smaller tax collection on profits of the enterprises in the exempted region. Rows A.1.a and A1.b of Table 5 show, respectively, the estimated costs for these concepts for each pertinent geographical area.23 18. Wages Subsidy. Private enterprises operating in the ZEs where DL 889 applies are entitled to a subsidy equal to 17 percent of the wages for contracting labor, with a ceiling of 25,024 monthly per ~ o r k e rThis implies that the subsidy i s more significant for contracting . ~ unskilled workers. This subsidy has a direct fiscal cost, shown in row A.2 of Table 5 specifying the geographical area where it i s incurred. The estimated figures assume that economic activity in the exempted areas would be the same inthe absenceof the free-trade zone benefits. This can over-dimension fiscal costs in the understanding that the benefits of free- trade zone potentially increase the economic activity and as a result fiscal collection. Still, this effect i s minimized if greater economic activity in the exempted regions comes mostly from interregional relocations. The administrative expenditures incurred by the State for the operation of the Free-trade Zones are implicitly included in the costs of the second category of exception instruments ("preferential assignment of transfers and public programs"). Companies in the mining, financial, and personal services sectors are excluded from this benefit. vi Table 3. Summary of Current Incentives AREA LEGISLATION YEAR MAINBENEFITS Arica Arica Law I(No. 19.420) 1995 Investment tax credit (10 percentto 40 percent); Export centers; Zero tariff; Export (Region I) Arica Law I1(No. 19.669) 2003 processing zone; Wages subsidy (17 percent); Free Trade Zone Law (DFL 341) 1975 Investment discount (20 percent); Duty-free airport; Purchasesby Mandate; De-earmarking Labor Subsidy (DL 889) 1975 real estate purchases. Investment Promotion Fund(DFL1.5) 1982 Iquique Arica Law I(No. 19.420) 1995 Duty-free airport; Export and commercial duty (Region I) Arica Law I1(No. 19.669) 2003 free zone; Wages subsidy (17 percent); Investment discount (20 percent). Free Trade Zone Law (DFL 341) 1975 Labor Subsidy (DL 889) 1975 Investment Promotion Fund(DFL15) Tocopilla Mining Export Processing Zone Law 2002 Free trade zone for mining supplier activities. (Region 11) (No. 19.709) Easter Island Easter Island Law (No. 16.441) 1966 Tax exemption; Income tax exemption for goods locatedon the island; VAT exemption for internal sales; Stamp tax exemption; Fuel subsidy ChiloC y Austral Law (No. 19.606) 1999 Investment tax credit (10 percent to 40 Palena Labor Subsidy (DFL 889) 1975 percent); Wages subsidy (17 percent); Tax (Region X) concessions on fiscal goods; Investment Investment Promotion Fund(DFL 15) 1982 discount (20 percent); Transportation and food First Lady Fellowships Law (No. 1988 and board fellowships for poor students. 18.681) AysCn Austral Law (No. 19.606) 1999 Investmenttax credit (10 percent to 40 (Region XI) Labor Subsidy (DL 889) 1975 percent); Wages subsidy (17 percent); Tax concessions on fiscal goods; Investment [nvestment Promotion Fund (DFL 15) 1982 discount (20 percent); Transportation and food First Lady Fellowships Law (No. 1988 and board fellowships for poor students. 18.681) Source: Ministry of Finance,Chile "Terms of Referencefor Assessing andReformulatingZE Policies" January 2003. vii Table4. Characterizationof the Incentives inEffect Freetrade zones No No No No Wages subsidy Yes No No Yes Investmenttax credit Yes No No Yes InvestmentPromotionFund Yes Yes Yes No Sales subsidy No No No No Source: MIDEPLAN. 19. Investment Tax Credit. Private enterprises located in Regions XI and XII, and in the provinces o f Arica and Palena can deduct a percentage o f the cost of the investments they make5 from their income tax payment. This percentage ranges between 10 percent and 40 percent, depending on the type and amount of the effective investments. The fiscal cost represented by this smaller tax collection i s shown in row A.3 of Table 5, according to the ZE where it i s incurred. 20. Investment Promotion Fund. Private enterprises located in Regions XI and XII, and in the provinces of Arica, Chilok, and Palena are eligible to a subsidy of 20 percent of the value of the investments they make. This subsidy i s not automatic, but requires the enterprise to apply for it and then a committee in the respective ZE selects the investments that will receive the subsidy. This mechanism, together with the fact that the resources available in each ZE are predetermined by the Law of Budgets of the Public Sector each year, implies that close to 80 percent of the projects submitted are not approved. This implies that the expected ex ante subsidy amounts to only 4 percent of the investment cost. The fiscal cost of this fund (to which FONDEMA, with similar characteristics in Region XII, i s also added) i s shown in row A.4 of Table 5, according to the ZE where it i s implemented. 21. Sales Subsidy. The Navarino Law (No.18.392) created four small "super free-trade zones" areas in Region XII; the comunas of Navarino (2,300 inhabitants), Timaukel (400), Porvenir (5,400), and Primavera (1,000). The enterprises located inthese areas pay practically no taxes. Furthermore, the State pays a subsidy equivalent to 20 percent of their total sales, provided that: i)the sales are not inRegion XII; and ii)local inputs, including labor, represent at least 25 percent of the cost of the output. The fiscal cost o f this subsidy i s presented in row AS of Table 5. Companiesinthe mining, agricultural, andtrade sectors are excludedfromthis benefit. ... V l l l Table 5. Total Cost of ZE policies, 2001 (a) (b) (c=a+b) (4 (e) (0 (g=d+e+f) (h=c+g) Arica Iquique Total Chilo6 and Region RegionXI1 Total ZE Total RegionI Palena XI Southern (RegionX) Area A. Fiscalincentivesfor private enterprises 1.Free trade zones a) VAT and customs duties1 65.8 65.8 12.3 12.3 78. 1 b) Tax on corporateprofits2 33.2 33.2 6.2 6.2 39.4 2. Wage subsidy 8.8 16.8 25.6 12.5 6.2 12.0 30.8 56. 4 3. Investmenttax credit 7.3 7..3 12.0 12.0 19..3 4. InvestmentPromotion Fund 0.75 0.1 0.6 8.8 9..6 10..3 5. Sales subsidy 5.9 5.9 5..9 TOTAL 16.1 115.8 132.6 12.7 6.8 57.3 76.8 209.4 B. Preferential assignment of transfers and public programs 1.Social spending 33.0 19.0 22.0 74.0 2. Investments 37.0 50.0 49.0 136.0 3. Miscellaneousexpenditures3 0.9 1.8 0.2 0.4 0.5 2.4 TOTAL 71.8 NA 69.2 71.4 0.6 212.4 C. TOTAL COST (C=A+B) 204.4 12.7 76.0 128.7 77.4 421.8 D.PERCAPITA COST 504.6 788.6 804.9 637.7 Panels A, B and C inUS$ million. PanelD inUS$. (1) It corresponds to 20 percent(18 percent VAT and 2 percent customs duties) applied to sales of the Free trade Zone within the region. (2) The estimationfor Region XI1was calculatedusing the effective ratio existing in Region Ibetweenthe cost for smaller collection of the tax on corporateprofits and the cost of smaller collections of VAT and customs duties. (3) It includesthe Regional TransportationSubsidy and the CORFO Investment Program. Source: Calculated on the basis of informationfrom the Ministry of Finance and MIDEPLAN. B. ZE Allocations of Public Expenditure Transfers and PublicPrograms 22. Analyzed Transfers. The preferential assignment of transfers and public programs to the ZEs i s calculated by estimating the differential of resources these areas receive per inhabitant, compared with the national average. This estimation i s made separately for two areas of transfers: i)social spending; and ii)investments. In addition there are miscellaneous expenditures that are executed directly inthe ZEs. 23. Social expenditure. Social expenditure i s assigned regionally in relation to: i)the provision of minimum standards of goods, services, and institutions; ii)local demand for goods and services (as happens, for example, with the portable education subsidies); and iii) poverty level of the population. The first parameter can be pro-ZE keeping in mind that the geographical location of these areas may imply greater costs to provide the minimum standards. The second, based on the demand, 'should not have a pro-ZE bias. The third could ultimately favor the ZEs, should they show highlevels of poverty. i x 24. Investments. The four sources of regional investment include: i)the National Regional Development Fund (FNDR), which assigns resources according to socioeconomic criteria and special territorial characteristics; ii)the Regional Assignment of Sectoral Investment (ISAR); iii)the Local Assignment of Regional Investment Program (IRAL);and iv) Programming Agreements. These four sources are regarded as "regional decision investments", and in 2001 included 46 percent of public investment. The remaining percentage i s made through investments carried out directly by the line ministries. 25, Miscellaneous Expenditures. These expenditures include two private programs of relatively small expenditure: i)Subsidy to Regional Transportation; and ii)CORFO Investment Program, carried out mainly inArica. 26. Estimation of Preferential Transfers. Table 6 shows the differential of estimated expenditure in favor of the ZEs, both for social spending and for investmenk6 It i s noted that inboth areas the ZEs receive special treatment. Thus, Region Ireceives inper capita terms 20 percent more in social spending (row A.2) and 85 percent more investments (row B.2) than the rest the country. Region XI receives 48 percent and 478 percent more in the respective areas, while Region XI1 receives 33 percent and 285 percent more, respectively. The conversion of these differentials into money appears in row A.4 for social spending and in row B.4 for investment^.^ Table 6. PreferentialAssignment of Transfers and Public Programsto the ZEs Chile Region1 RegionXI Region XTT A. Social Spending 1. Per inhabitant (US$) 404 484 599 536 2. Percent Difference with respect to Chile - 20 percent 48 percent 33 percent 3. Preferential expenditure per inhabitant (US$)l 80 195 132 4. Total preferential expenditure (millions US$)2 0 33 19 22 B. Investments 1. Per inhabitant (US$) 108 200 624 416 2. percent Difference with respect to Chile - 85 percent 478 percent 285 percent 3. Preferentialexpenditure per inhabitant (US$)1 92 516 308 4. Total preferentialexpenditure (millions US$)3 37 50 49 C. Population (thousands) 405.2 96.4 159.9 (1) Difference betweenspendingper inhabitantinthe regionandthe total for Chile. (2) Same as row A.3 multipliedby the population(row C). (3) Sameas row B.3 multiplied by the population(row C). Source: MIDEPLAN. ~ Inorder to calculate the spending differential in these areas the study considers only Regions I, and XI1as XI, ZE. 'The expenditure differential i s not corrected for differences in the regional cost of living. As pointed out in Chapter 11, these differences are significant only for regions XI and XII. X 27. Preferential Distribution of Civil Servants. The preferential assignment of transfers and public programs in favor of the ZEs has also implicitly in its cost a preferential distribution of civil servants and their respective wages.' Indeed, Regions I, XI and XI1have respectively 36 percent, 149 percent, and 133 percent more civil servants per inhabitant than the country as a whole (panel A Table 6); that in addition receive wages, on average, 20 percent higher in Region I, percent higher in Region XI and 40 percent higher in Region 33 XI1 (panel B, Table 7).9 If we consider the first differential as a "quantity effect" and the second as a "price effect", the multiplication of both results inthe "total preferential effect" in the distribution of civil servants and their wages. Thus, the provision of civil servants in Region Iimplies a 63 percent higher expenditure per inhabitant than in the rest of Chile. This percentage reaches 231 percent and 212 percent in Regions XI and XII, respectively (panel C, Table 6). Chile Region I RegionXI Region XI1 A. Quantity Effect Civil Servants per thousand inhabitants 10 13 24 22 percent Difference with respect to Chile 36 149 % 123 % B.Price Effect (index base 100) Basic Salary (a) 100 100 100 100 Standard Assignment (average) (b)' 40 40 40 40 Area assignment (average) (c) 10 40 60 70 Total (d=a+b+c) 150 180 200 210 percent Difference with respect to Chile 20 % 33 % 40 % ie=(d- 150)/150)* C. Total Effect (C=A*B) II 63 % 231 % 212 % (1) The standardassignment vanes according to the type of civil employee, for example, it is muchhigher for judges. (2) This i s the regional average differential, which varies between the comunas within the ZE. For example, in Region XI1some comunas reacha differential of 120percent with regard to Chile. Source: Calculated on the basis of informationfrom the Office of Budgets of the Ministryof Finance. C. TotalCost of ZE Policies 28. Total Cost. Table 5 summarizes the costs of the current ZE policies in Chile for the year 2001. Panel A summarizes the costs of the fiscal incentives for private enterprises; panel B the costs of the preferential assignment of transfers and public programs; and Panel C the total of both. It i s confirmed that the total cost o f these policies i s US$421.8 million annually, which i s disaggregated practically inequal parts between its two components. 29. Cost by Region. The cost of the preferential assignment of transfers and public programs i s distributed inpractically equal parts among regions I, XI and XII. Incontrast, the 'The distribution of civil servants and their wages also reflects the administrative expenditures incurred by the State in operating the Free Trade Zones and other current benefits in the ZE. The wage differential i s not corrected by differences in regional cost of living. In any case, the wage differential i s always greater than the differences in cost of living. xi cost of the fiscal incentives for private enterprises i s mostly concentrated in Region I(63 percent), and to a lesser extent in RegionXI1(27 percent). Thus, 48 percent of the total cost of the ZE policies i s incurred in Region I,18 percent in Region XI, and 31 percent in Region XII. This distribution i s different if it i s analyzed in per capita terms. Indeed, ZE policies imply an annual expenditure of US$504.6 per capita in Region I, figure that increases to a US$788.6 inRegion XI and to US$804.9 inRegionXI1(panel D Table 5). EVALUATION ZEPOLICIESINCHILE OF 30. Criterion for Evaluation. The present evaluation utilizes statistical and qualitative analyses to measure the degree of success of ZE policies. To this end it i s based on three ' indicators: i)regional population (with the understanding that in the absence of compensatory policies the population would migrate from the ZE because it would be less attractive); ii) economic activity indicators; and iii)socioeconomic indicators. In addition the international experience i s considered as a comparisonparameter. 31. Evaluation Method. The evaluation tries to answer two questions: i)given the ZE policies, what has been the relative performance of the ZE with respect to Chile as a whole?; and ii)in view of the fact that the ZE have effectively had significant performance, i s it possible to attribute this performance to the ZE policies? A. Relative Performance of the ZE 32. Regional Population. The census of 1970 i s utilized as baseline to analyze the evolution of the regional population, in view of the fact that important ZE policies were implemented in the mid-1970s (the Free Trade Zones law and the wages subsidy). It was observed that in the period 1970-2002the aggregate population of Regions I, XI and XI1grew by 113 percent, a higher percentage than total population growth inthe country, which was 70 percent (Table 8). This implied that the population of the ZEs went from representing 3.54 percent of the total population in 1970, to 4.44 percent in 2002. This growth has been mainly ledby Region I. 33. The analyzed figures suggest that ZE policies would have met the implicit objective of avoiding their depopulation, especially in Region I.This, since share in the national population grew in regions I, XI andXII, or was at least maintained, inthe period 1970-2002. Inany case, it shouldbe notedthat this analysis does not demonstrate a direct causality of ZE policies over population growth, but only a strong positive correlation. xii Table 8. PopulationGrowth, 1970-2002 Year RegionI RegionXI RegionXI1 ZE Total CHILE 1970 Population 175,208 50,300 89,443 314,951 8,884,768 percent 1.97 0.57 1.01 3.54 100.00 1982 Population 275,144 66,361 131,914 473,419 11,329,736 percent 2.43 0.59 1.16 4.18 100.00 1992 Population 339,579 80,501 143,198 563,278 13,348,401 percent 2.54 0.60 1.07 4.22 100.00 2002 Population 428,594 91,492 150,826 670,912 15,116,435 percent 2.84 0.61 1.oo 4.44 100.00 PopulationGrowthRates 198211970 57 % 32 % 47 % 50 % 28 % 199211982 23 % 21 % 9 % 19 % 18 % 200211992 26 % 14 % 5 % 19 % 13 % 200211970 145 % 82 % 69 % 113 % 70 % Source: National Instituteof Statistics, Censuses 1970, 1982, 1992, and2002. 34. Economic Activity. This analysis focuses on the operations of the Free Trade Zone of Iquique inRegion I(ZOFRI). InPanel A of Table 9 it i s observed that the number of business enterprises grew rapidly in the period 1976-1998, but has been falling since then. The evolution of total sales (Panel B) also shows this trend. The principal explanation for the lower activity in the period 1999-2002 i s the dramatic fall experienced by the average tariffs in Chile, going from 35 percent at the beginning of the 1980s to 6 percent today. This has implied a systematic reduction inthe attraction o f the free trade zones. Inaddition, ZOFRI has faced new competition from free trade zones created in Peru and Bolivia, and has been affected b y the effects of the Asian crisis. With regard to industrial enterprises, it i s observed that until 1995 these grew slightly and were distributed equally between Arica and Iquique. However, with effectiveness of the Arica Law I(No. 19.420) a bias in favor of this city took place. This suggests that the advantageous conditions offered by that law have effectively encouraged the establishment of enterprises in Arica, although it i s not possible to determine what percentage has corresponded only to relocations. 35. The analyzed figures suggest that ZOFRI has had a positive impact on the economy of Region I.However, it should be noted that its better days are probable already over. Furthermore, it should be emphasized that the impact of ZOFRI has been strengthened by the advantageous geographical location of Region I,which for foreign trade purposes i s totally contrary to the traditional concept of an extreme area. Still, it i s possible to propose the hypothesis that the existence o f ZOFRI has made it possible to effectively make the most of the geographical advantages of Region I. ... X l l l 36. Socioeconomic Indicators. In Table 1 it i s observed that in general the ZEs show significant performance in socioeconomic terms. The analysis that follows studies the evolution that such variables have had (Table 10). Inthe first place, it i s confirmed that in the period 1990-1998 Regions XI1 and Ifell slightly in the regional ranking of GDP per capita (mainly because of the miningboom experienced in Regions I1and 111),but continue to be in the first five places. In turn, Region XI improved its relative position, but remains under the national average. Table 10. Socioeconomic Indicators, 1990-1998 Region Per capita GDP Poverty Infant mortality Dropout rate Dropout rate (thousands of $ of (each 1000live Primary Secondary 1986) (percent) births) Education Education (perInt) (per nt) 1990 1998 1990 1998 1990 1998 1990 1998 1990 1998 I 391.1 626.8 28.3 16.1 12.5 8.9 1.9 2.6 7.0 5.3 I1 683.1 1294.2 34.1 13.2 15.7 13.0 1.5 1.7 8.5 3.8 I11 308.5 651.2 34.2 28.5 20.2 14.9 1.5 1.1 8.2 4.6 IV 216.5 316.6 45.5 25.1 16.3 11.3 1.7 1.o 6.9 5.7 V 280.1 368.0 43.0 18.8 15.4 10.9 2.4 1.7 6.9 4.5 VI 295.3 396.1 41.0 22.7 14.6 10.6 1.8 0.9 7.2 3.4 VI1 195.1 301.2 42.7 29.3 16.7 10.1 2.4 1.1 7.5 4.1 VI11 242.3 298.5 48.2 32.3 18.7 13.4 2.4 1.o 8.4 3.9 IX 126.3 188.1 45.1 34.3 26.6 12.4 2.9 1.2 10.0 4.8 X 172.8 274.1 40.1 29.4 21.5 11.5 2.4 1.4 8.5 5.3 XI 247.8 377.7 31.0 14.8 21.6 12.1 2.7 1.o 10.2 5.7 XI1 824.7 869.7 30.0 11.8 16.1 9.2 0.7 0.6 4.2 2.9 MR 338.4 540.32 32.9 15.4 14.7 9.7 2.4 1.5 6.7 4.1 Chile 330.1 550.1 38.6 21.7 16.8 10.8 2.3 1.4 7.4 4.3 Source: National Instituteof Statistics and Surveys 1990 and 1998 37. With regard to the evolution of the social indicators, in the period 1990-1998 these experienced a significant improvement at the national level. As a result, to evaluate the performance o f the ZEs it i s important to focus on their relative position. With regard to the incidence of poverty, Region XI1 consistently presents the lowest indices of the country. Region XI, although falling slightly in the ranking, maintains a better than average performance. Inturn, Region Iimproves position in the ranking, going from being average to being better than average. With regard to infant mortality, Region Iconsistently presents the lowest indices of the country. Region XI1 improves notably, moving from sixth to second place. Although Region XI moves forward three places, it has indices worse than the national average. Finally, with regard to the school dropout rate, Region XI1consistently presents the best indicators, both in primary and secondary education. Region XI presents an important improvement in primary education, going from last to third place, although in secondary education it remains at the end of the list. Region Ishows a relative worsening performance, xv going from being better than average to being worse than average in both educational levels. Moreover, inprimary education it shows an absolute worsening. B. Effectiveness of ZEpolicies 38. Region I.The performance of the ZEs in the different indicators considered is the result of various factors, among which are ZE policies. In this regard, the analysis presented on Region Imakes it possible to conclude that there i s a strong positive correlation between these policies and regional performance, but not causality. However, the hypothesis of causality gathers strength when considering the different economic effects experienced in Arica and Iquique as a result of differences in the policies that have benefited each of these cities. Even assuming causality, three warnings should be made with regard to the effectiveness of the ZE policies in favor of Region I. First, that possibly the same results could have been achieved more efficiently through better-targeted specific instruments. Second, that Region Ii s not really an extreme zone interms of foreign trade, and as a result its exceptional growth could be based on its privileged geographical location rather than on the ZE policies. Still, these policies could be regarded as the push needed by the region to make the most of its competitive advantages. Third, regardless of the effects they had in the past, many o f the ZE policies have been losing effectiveness in Region I, especially the free trade zones. This i s due to the dramatic reduction of tariffs experienced inthe country." 39. Regions XI and XII. These regions can effectively be described as extreme, not only because of their distance from the capital city, but also because of their geographical isolation, cost of living, and distance from the poles of international trade. Although the analysis presented for Regions XI and XI1does not make it possible to conclude causality between ZE policies and regional performance, there are arguments in support of such hypothesis. In particular, given the international experience, it was expected that in the absence of compensatory policies Regions XI and XI1 would have had their share in the national population diminished in the period 1970-2002. However, Region XI increased it and Region XI1maintained it. 40. Analysis of Regional Structural and Marginal Growth. This analysis makes it possible to estimate the growth of employment and products that the ZEs would have experienced in a given period had they maintained their industrial structure and grown at the national average in each economic sector. This estimation corresponds to "structural growth." The difference between the latter and effective growth corresponds to the "regional marginal growth", which represents the effect of the changes in the regional productive structure. In turn, these changes could be the result of the ZE policies. Table 11shows that Regions Iand XI present a positive regional marginal growth in the period 1989-2001, both in employment and in product, which could prove a positive effect o f ZE policies. The opposite could be argued for Region XII. loA t any rate, other elements of the free trade zones, such as their more flexible regulatory framework, can indeed continue to strengthen the competitive advantages of the region. xvi (a) (b) (c=a-b) Effective Growth StructuralGrowth Regional Marginal Growth Chile 44 44 RegionI 53 48 +5 RegionX I 47 35 +11 RegionXI1 22 48 -26 Chile 113 113 Region I 126 114 +13 RegionX I 107 97 +10 RegionXI1 33 101 -68 I I I I I Source: NationalInstituteof Statistics. PROPOSALSTO IMPROVE THE REGIONAL DEVELOPMENT POLICIESINCHILE A. Improvementsof Current Instruments 41. Free Trade Zones. The existing free trade zones in Chile do not necessarily have uniform legislation, but in general include the following benefits: i)exemption from payment of customs duties; ii)exemptions and special arrangements with respect to payment of VAT; iii)taxexemptiononcorporateprofits;andiv)taxexemptiononrealestate." Ashasbeen mentioned, many of these benefits have lost their effectiveness as,the country has liberalized its foreign trade. However, they have not been updated due to resistance to change from actors in the ZEs who at any rate derive income from them. The position of these agents is strengthened with the presence o f free trade zones in the neighboring countries and with the absence of an alternative regional development policy. Following i s a review of each benefit typically considered by the Chilean free trade zones: Exemption from Payment of Customs Duties. Due to the economic and commercial integration processes, this benefit has become insignificant in direct monetary terms. However, it continues to be valued by the users because it implies a light and non- bureaucratic regulatory framework that facilitates trade. In this regard, maintaining this regulatory scheme and even expanding it to the entire country should be evaluated. Exemptions and Special Arrangements with respect to Payment of VAT. The enterprises that export outside the free trade zone, either to the rest of Chile or outside The Navarino Law (No. 18.392) also includes a subsidy equivalent to 20 percent of sales, making it highly inefficient and distorting. xvii the country, do not produce fiscal costs due to smaller collection of VAT. In the first case, this tax i s paid inlater stages of the productive process, while in the second case it does not differ from what happens with exports from any other area of the country. Thus, the smaller collection of VAT only takes place on local consumption in the region exempted from payment, which includes consumption of residents and tourists. Although this cost may not be high, it does not have justification as an export promotion strategy in the free trade zones. Furthermore, in terms of well being it possibly only replaces consumption from one region to another and generates administrative and control costs. Regarding this diagnosis it i s possible to suggest the dismantling of the benefit. Inlight of possible resistance maintaining a light regulatory scheme i s suggested, maintaining the benefit but restricting it to specific activities of export/import enterprises, and compensating the poorer population of the region through targeted transfers. iii)Tax Exemption on Corporate Profits, This type of exemption encourages tax evasion, generating inefficiencies in the assignment of resources and high administrative and control costs. Tax evasion occurs because the benefit i s applied on net income recorded in the exempted region, allowing the company to move gross income and costs from one region to another in order to minimize its tax payments. In the worst scenario it encourages enterprises to establish their headquarters in the free trade zones, but without generating employment or additional production, at the expense of the rest of the regions of the country. Accordingly, it i s recommended that this privilege be abolished (or at least restricted to new enterprises and for a given limited time). When it i s deemed appropriate to promote economic activity in a region this should be done, encouraging the creation of value, such as development of human capital, and not rewarding the general profits o f the enterprises. iv) Tax Exemption on Real Estate. This benefit is conceptually effective in altering the decision o f location of enterprises. However, in practice it i s a weak incentive, since the tax rate i s low and the tax base i s usually undervaluedwith regardto market prices. Inaddition, itis acommunitybenefittax, which meansthat the municipalitiesassume the fiscal cost and diminishes their capacity to provide goods and local public services. In this regard, this instrument could be improved if the real estate tax payment was considered a tax credit on corporate profits. Thus the central level would be the one which would assume the fiscal cost of the benefit. 42. Wage Subsidy. This subsidy attempts to standardize, in the private sector, the discount received by civil servants working in the ZEs. The logic behind the subsidy i s to compensate for the alleged differences in regional cost of living, as well as to activate the labor markets of the more economically depressed regions. However, this same logic does not justify that the subsidy i s only applied to the ZEs and not to all the regions according to the effective differences that need to be compensated. In fact, in practice the subsidy does not coincide with the differences observed in the cost of living. Even more so, in terms of employment creation, the discount to labor should be smaller for those jobs of lesser mobility and should reward the new jobs and not operate as a simple reduction to the aggregate list of xviii salaries.l2Interms of strengthening regional competitive advantages, it should not be biased in favor of those low-income and thus less skilled workers, as occurs today given the ceiling of the benefit per worker. 43. Accordingly, it i s recommended that this instrument be modified so that it reflects effective differences in the regional cost of living (which in the case of the northern ZEs are practically non-existent), and not be biased against skilled manpower.l3Furthermore, the discount could be applied not only for contracting of labor, but also for the development of human capital in the area. With regard to the pensioners who live in the ZEs and that are also entitled to the discount, the benefit should be eliminated. In exchange a portable benefit should be implemented for the pension contributions made during the active stage in which they worked in any ZE. 44. Tax Investment Credit. The objective of this instrument is to encourage the formation of physical assets in the ZE, in the understanding that this would have a greater social return than the private one, which inmany cases i s debatable. The different instruments consider differentiated discounts according to amount and type of projects, in addition to a series of non-eligible investments. All this generates high administrative and control costs of the instrument. 45. The international evidence i s not conclusive with regard to the effectiveness of this type of instrument. Even if accepting that it was, current instruments in Chile should be modified in such a way as to simplify their rules of operation and thus diminish their administrative costs and the resourcefulness o f contributors aimed at attempting to break their rules. Inparticular, the benefit rate should be standardized and be much smaller (for example 20 percent) than the current maximumlimit; and the minimumamount to be invested should be much smaller than the current one, to make it possible for S&ME to also take advantage of the benefit. Finally, the benefit could be gradually eliminated for the northern zone since the rationality that would justify it at present seems reasonable only inthe southern ZEs. 46. Investment PromotionFund. This instrument seems highly bureaucratic and over- regulated. This minimizes its capacity to encourage the operation of the private sector, which i s made worse because this sector perceives it as a hardly transparent and arbitrary instrument. For this reason, this instrument should be eliminated without replacement. '' l2 In this regard, the international experience indicates that this type of subsidies to a great extent displace employment from adjacent regions. Thus, no more than 40 percent of the subsidized jobs would correspond to enuinely newjobs. This development of regional competitiveness policy should not be confused with social protection policies for the neediest population. xix B. TowardDifferentiated Policiesby Region: From Extreme Zones to StrategicZones 47. Need for Reforms. The present study has found evidence on the lack of a consistent development policy of the ZEs. It has found scattered legislation, possibly resulting from pressure exercised by different interest groups over time. Because of this, the purposes of the legislation are difficult to understand and their instruments difficult to use, except by those agents who have developed the skill to obtain income from them. These same actors are those who will possibly hinder the implementation of reforms, arguing that similar policies are applied in the neighboring countries to which no advantages should be given. An additional element confirmed by the present study i s that currently ZE policies do not take into account the geographical, demographic, economic, and social differences o f the different ZEs, which are especially evident between the regions in the northern extreme and those in the southern extreme. This lack of consideration of regional special characteristics affects the effectiveness of the policies. 48. A Development Strategy for the North: Toward a Commercial Platform in RegionI.The geographical location of Region Iconstitutes a relevant competitive advantage that should take this opportunity to be transformed into the commercial platform of the transactions between Asia and Chile, and even between Asia and neighboring countries and MERCOSUR. For this to take place, progress should be made in: i)ensuring commercial and economic linkages between Chile, Peru, and Bolivia through a North American Free Trade Agreement (or through the FTAA); ii)improving the port and land transportation infrastructure in the region, including transnational roads; iii)developing efficient administrative and management capacity in the areas of finance, insurance, communications, transportation, and customhouses, among others; and iv) having a transparent regulatory framework, simple and efficient with regard to the creation of enterprises, personnel management, and foreign investment, among other aspects, and in addition having local capacity to manage it. 49. This strategy implies an adaptation of current ZE instruments inthe region, which can be done neutrally interms o f fiscal collection. For example, resources can be reassigned from the wages differential paid to civil servants in the region-which i s excessive in comparison with the difference in cost of living-and the preferential assignment of transfers and public programs-which i s excessive to achieve socioeconomic indicators similar to the national average. In the case of the Wages Subsidy, this should be replaced with another benefit that rewards the creation of new jobs, in new industries, and attracts preferably skilled manpower (for example, a five-year tax exemption for professionals who settle inthe region). 50. It i s to be expected that this strategy would result in a plus sum game, since it should generate additional jobs and not only imply relocations at the expense of the rest of the regions of the country. This contrasts, for example, with the strategy to transform Region I into a specialized area in information technology. In this latter case it would be expected that Region Iwould attract enterprises that otherwise would have been located in the central area of the country, which has competitive advantages for this. xx 51. Highlighting the Regional Policies for the South. The geographical and climatic characteristics of Regions XI and XI1generate important competitive advantages for tourism and aquaculture. While Region XI has already developed this sector and Region XI1 has concentrated on mining, the tourism sector maintains a very highpotential without developing inboth regions. Inthis context, the development strategy of these regions should consider: i) strengthening the respective leader sectors in each region; and ii)diversifying the regional productive base, with emphasis on the tourism sector. 52. For the foregoing it i s indispensable to invest in infrastructure to diminish the costs of travel in the region and its connection to the rest of the country. However, the current exception instruments for these ends seem non-sustainable in the long run. Another important element i s the regional integration with Argentina (Austral Plan) that among other benefits will make it possible to take advantage of economies o f scale in the tourist promotion of the southern zone. C.Preparing the Groundfor Economic Growth and Long-term Developmentfor the Whole of Chile (not only the ZEs) 53. Regional Policies Aimed at Poverty Reduction and Growth. Chile needs to change its current defensive and static ZE policies, with a more dynamic and aggressive approach sustained by the regional competitive advantages and targeted to reduce poverty. These policies should be permanently monitored against performance indicators (related to poverty and growth) that make it possible to ultimately "graduate" beneficiary regions when they exceed certain standards. This whole approach can go beyond the current ZEs and be applied to all the regions of the country. i.)PovertyReduction.Theregionalpovertyreductionpoliciesshouldbedistinguished from those national policies targeted to poor individuals. The policies at the regional level should be focused on materializing investments in infrastructure and public services. Furthermore, they should aim at the development and availability of quality human capital in the region. For these efforts to be effective, they should be framed in a consistent regional policy. This implies, for example, that human resources development should be consistent with the existing demand for them in the region, which in turn will be a reflection of the competitive advantages of the same.14 This approach requires a public-private coordinated effort. At the national aggregate level, the approach of regional policies to reduce poverty implies that the assignment of resources and exception benefits should be consistent with the socioeconomic status of each region. Certainly, this would lead to a very different distribution of resources from the current one, resulting from the preferential treatment given to the ZEs. l4For example, in Regions XI and XI1 human resources should be developed in the areas of tourism and aquaculture, while in Region Ithey should do it in the areas of trade-related services. xxi ii)Growth.Apolicyaimedatpromotingregionalgrowthshouldbebasedonananalysis o f the long-term potential of each region. Thus, based on the competitive advantages of each of them, the specific supports required to materialize them should be determined. iii)Forthedevelopmentofapolicywiththesecharacteristicsitisusefultoconsiderthe following elements of the European Union regional support policy: i)the regions are defined based on their economic characteristics; ii)eligibility to receive assistance i s determined on the basis of objective criteria; iii)eligibility to receive assistance i s dynamic intime, makingthe supports limited intime (contrary to what occurs with the majority of the benefits to the ZEs in Chile); iv) assistance i s concentrated on infrastructure projects (and to a lesser extent in human capital development projects); and v) assistance requires regional cofinancing of the projects, making it possible to identify local priorities. 54. Strengthening Governance Capacity at the Regional Level. Inorder to successfully implement the aforementioned regional policies aimed at the reduction of poverty and growth, it is necessary to strengthen the governance capacity of the regionalinstances. These instances should be well informed, proactive and expeditious and be in line with local preferences and potentialities. They should avoid over-regulation and bureaucracy, and should have sufficient decision-making power. SUMMARY OFEVIDENCE RECOMMENDATIONS AND 55. Chile has a set of instruments, relatively scattered, that grants preferential treatment to the geographical regions of the country qualified as ZE. These instruments and the regions where they are applied have historically been justified for geopolitical reasons, with a significant lag with regard to the evaluation of their costs and impact. In this regard, the present study represents the first effort at systematic evaluation. 56. The study identifies two major groups of instruments in favor of the ZEs: i)fiscal incentives to private enterprises; and ii)preferential assignment of transfers and public programs. The annual cost of the first i s US$209 million, and for the second US$212 million, implyinga total cost equal to US$421 million annually. 57. From their application, an important positive correlation i s confirmed between the indicated set of instruments and the performance of the ZE in terms of their population size, economic activity, and socioeconomic indicators. Although the study does not prove statistical causality, it presents elements that would sustain the hypothesis of a positive impact of ZE policies on the beneficiary regions. In any case, this would not imply efficiency of the current instruments, because institutional design problems have been identified in most of them. xxii 58. Despite the foregoing, the study suggests not focusing on the past performance of the ZE policies and recommends going beyond the refinement of the current instruments (for which at any rate it submits specific recommendations). In fact, it i s concluded that the concept of the policies inquestion would be obsolete, overcome by the changes that Chile and the world have experienced in the last thirty years. This i s exemplified in the free trade zones, one of the most representative instruments of the ZEs, which have lost their raison d'Ctre with the liberalization of the economy and foreign trade. 59. Along this line, replacing the concept of "extreme zone" with that of "strategic zone", and applying it to all the regions of the country i s recommended. Thus, implementing policies that take into account the special characteristics of each region, especially their competitive advantages, the bottlenecks that hinder their development, and their level of poverty i s recommended. In the case of the current ZEs, this would imply quite different strategies for the regions of the north and the south, because the former have advantages of location to become an international commercial platform, while the latter suffer real isolation characteristics. Furthermore, introducing the level of regional poverty as an indicator of need would lead to a distribution of regional resources very different from the current one, since the current ZEs are far from being the neediest regions. 60. Accordingly, the indicated strategy implies developing regional policies aimed at poverty reduction and growth, complemented with a strengthening of the governance capacity at the regional level. Regardless of the specific instruments that are adopted, it i s recommended that these be transparent in their operation, that they do not imply over- regulation, that they be periodically and systematically evaluated, be dynamic (in the sense of not providing perpetual assistance to regions that no longer require it), and that they are flexible (inorder to adapt to the reality of each region). 61. It is recognized that these changes are quite radical and therefore difficult to implement. Thus a transition strategy that compensates for the loss of existing benefits i s required. This transition strategy should be especially careful not to repeat the historical dynamic of adding instruments without eliminating those deemed inefficient or obsolete, and to add beneficiary localities without "graduating" those that no longer need preferential support. xxiii CHAPTER 1. INTRODUCTION AND TERMSOF REFERENCE 1.1 The following Report was commissioned by the Ministry o f Finance, in order to analyze the fiscal impact of the various policies aimed at supporting the development of the Zonas Extremas, assess the benefits of these policies in achieving intended results and recommend policy changes in terms of fine tuning current instruments or developing new strategic policies. 1.2 With an annual real GDP growth rate of 5.4 percent over the decade of the 1990s and a real per capita growth rate of 4 percent (compared with 2.5 percent and 1.3 percent, respectively, for Latin America as a whole), Chile has legitimate claim to the title of "Southern Tiger". Supporting this view i s that Chile has run budget surpluses for 14 out of the last 15 years, has topped the Economist Intelligence Unit's E-Readiness Ranking 2002, and has earned the ranking of the 20th most competitive economy in the world (2002 World Competitiveness Yearbook). Beyond these economic performance data, Chile also has social and socio-economic indicators that are the envy of its neighbors. And all of this from a country that can also claim to be geographically challenged - a long linear territory (nearly 40 times as long as its average width), and a location on the periphery of the globe with geography as diverse as that of the earth's continents. For political and administrative purposes, Chile divides its diverse territory into 13 regions, 50 provinces and 341 municipalities. Apart from the capital region (Regidn Metropolitans de Santiago, referred to as the Metropolitan Region, MR), the other 12regions are numberedconsecutively, beginning with Region Iat the Peruvianborder and extending to Region XI1at the southern tip of South America. THECONCEPTOFZONASEXTREMAS 1.3 The Zonas Extremas comprise Region I(Tarapacd) plus the provinces of Tocopilla in Region I1 in the north of Chile, and Regions XI and XI1 (AysCn and Magallanes respectively) plus the provinces of Palena and Chilo6 in Region X in the south of Chile. The Isla de Pascua (Easter Island), 4500 kilometers into the Pacific i s occasionally considered as belonging to the ZEs as well. Geography, history and geopolitics are key to understanding the Zonas Extremas and ZE policies. Region Ii s a coastal desert while region XI1i s the glacial sub-Antarctic southern tip of the continent. Distance-wise, Iquique, the capital of Region Ii s some 1,800 km from Santiago, while Punta Arenas, the capital of Region XII, i s 3,000 km to the south of Santiago. While there are excellent highways connecting Santiago with the north, the southernmost and territorially fragmented territories in the south can still only be accessedby boat or ~1ane.l~. 1.4 The Zonas Extremas are also strategically important geo-politically. These areas were incorporated into Chile in the latter part of the 19th century after several military and diplomatic battles with Argentina (Regions XI and XII) and with Bolivia and Peru (Region l5Territories in the south can also be accessedby roads coming from Argentina. 1 I).Inorder to ensure the territorial sovereignty, national integration andeffective l6 administration of these regions, successive Chilean governments have instituted a series of development policies targeted on the ZEs (Table 1.1). These include the designation of Region Iand Region XI1 as free-trade zones (Zonas Francas) as well as a variety of wage, investment and tax concessions, all of which are detailed later inthe study. They also include Chilean-wide policies that have special provisions for the ZEs, such as the allocation of funds for the regions. While there i s no explicitly designated set of goals that these policies are designed to serve, one would not be far off by asserting that they are designed, inter alia, to strengthen the administration of these territories, to enhance the economic development of the regions and to increase the standard of living of residents, presumably all of this designed in turn to serve the larger objective of increasing their population and thereby securing their territorial integrity. Not surprisingly, this set of objectives has come to be viewed as an integral part of Chilean nation building and, therefore, has taken on the role as a national icon. Table 1.1OldLegalDefinitionsofExtreme Zones" "The extremes North and South of the country have the characteristics of a colonization zone, scarce population and incompleteperspective or advantage of their natural resources. These zones are high priority and shouldfocus on overcoming these aspects." (National Development Policy, ...."infirst Organizacidn de Planijicacidn Econdmica Global, ODEPLAN, 1968,46). place, the strategic nature of the extreme zones, taking into account the objectives of national security, which requirefor integrative development, a conscious and planned efort on behalf of the State to encourage growth, increase its population and create a stable and dynamic economic platform" (National Strategy for Regional Development, ODEPLAN,1975, 13). ...."aprogram of public investmentfor territorial compensation, focused onfinancing diferent regional activities, social and economic infrastructure for an equitable and in agreement territorial development" (Definition of the FNDR, Constitutional Organic Law of the Govemment and Regional Administration, LOCGAR, 1993). l6RegionI1(Antofagasta)was also annexedinthe war of the Pacific with PeruandBolivia (1879-1883), butit is not includedinthe definitionof the Zonas Extremas. l7 originalinSpanish: The "Los extremos norte y sur del pais presentan caracteristicas propias de una zona de colonizacidn, con un a poblacidn escasa y sin una prospeccidn ni aprovechamiento mds acabado de sus recursos naturales. Estas Zonas requieren alta prioridad dirigida a superar 10s aspectos antes notados" (Politica de Desarrollo Nacional, Organizacidn de Planificacidn Econdmica Global, ODEPLAN, 1968, 46)....."en primer lugar, destuca el cardcter estrat6gico que tienen las regiones extremas del pais, desde un punto de vista de 10s objetivos de seguridadnacional, 10s que demandan para su desarrollo integral, un esfuerzo concientey deliberado por parte de Estado para inducir su crecimiento, incrementar su poblacidn, y generar un a base econdmica estable y dindmica `` (Estrategia Nacional de Desarrollo Regional, ODEPLAN, 1975, 13) ....I'Un programa de inversionespdblicas, confinalidades de compensacidn territorial, estimado a1financiamiento de acciones en 10s distintos dmbitos de infraestructura social y econdmica de la regidn, con el objeto de obtener un desarrollo territorial armdnico y equitativo." Definicidn FNDR, Ley Orgdnica constitucional de Gobierno y Administracidn Regional,LOCGAR, 1993. 2 THETERMSOFREFERENCE ASSESSINGANDREFORMULATINGZEPOLICIES FOR 1.5 Even though these underlying objectives with respect to the ZEs remain valid today, it is fully consistent and appropriate to ensure that the specific initiatives designed to implement these objectives remain effective both in their own right and in light of the manner in which Chile and the rest of the world have evolved. For this, among other reasons, the Ministry of Finance of Chile requested the World Bank undertake a qualitative and quantitative assessment of the effectiveness and efficiency of the regional development instruments targeted on the ZEs. As part of this assessment, the Bank was encouraged to suggest improvements in these instruments and/or to draw from best practice elsewhere in the world to propose alternative instruments for ZE development. The general and specific objectives contained inthe terms of reference appear inTable 1.2. 1.6 Inorder to address this research agenda, the Bank assembled a team of Chilean and international experts. The team as a whole spent two separate weeks in Chile for data collection, meeting with officials and experts, and internal discussion and deliberation. As part of the initial meeting, the team visited Region Iand RegionXII, where we again met with officials, experts, politicians and various civil society associations. The team arranged with the Bank to have other individuals visit other parts of the ZEs (e.g., Aystn, Region XI) and report back to the team. The final annex of this report details the work procedures and presents the roster of those who made themselves available for special meetings. The Bank take this opportunity to formally thank these people as well as to thank Chileans for their generous hospitality while the team were privileged to be visiting their country. Table 1.2 Terms of Reference 3 OUTLINE OF THE STUDY 1.7 The role of Chapter 2 (Characteristics ofthe Zonas Extremas) i s to provide a few characteristics of the ZEs, such as population and density. 1.8 Chapter 3 then turns to the difficult task of describing and quantifying the economic costs of the various ZE fiscal and non-tax incentives and programs - difficult at the best of times, but especially so in light o f a paucity of data in several key areas. Nonetheless, within these constraints and employing appropriate assumptions, the report present an aggregate estimate of the all-in costs of the set of ZE policies. 1.9 Further characteristics of ZEs such as gross regional product, income and selected social indicators will serve Chapter 4 to emphasize the similarities and differences not only among the regions that comprise the ZEs, but also between the ZEs and the remaining regions o f Chile. Moreover, assessing the benefits of ZE policies i s the subject matter of Chapter 4. This is a two-part task. The first i s to compare economic and social performance in the ZEs with the relevant indicators for Chile as a whole. If these indicators perform better inthe ZEs, then the second task i s to assess whether this i s likely the result of ZE policies. The next section of the study dealing, for example, with alternative development strategies for the ZEs (and for Chile more generally) will be informed by various of these ZE indicators. 1.10 Chapter 5 begins with an assessment of ZE policies. It then focuses, in turn, on the manner in which the existing set of ZE policies could be reformed to make them more effective, on the range of alternative potential development strategies for the Regions comprising the ZEs, and finally on a series of regional development proposals based on best practice elsewhere. 1.11 Interms of the objectives and, to an important degree, of the instruments as well, ZE policies have not changed much over recent decades. For example, the Zonas Francas or free-trade areas were implemented inthe mid 1970s. However, the overall socio-political and economic environments in which these ZE policies operate have, in selected areas, altered dramatically. Hence, regional development initiatives that may have resonated well with the then-existing structural and policy environments may no longer do so inthe face of changes in the underlying environment. The remainder of this chapter focuses on three such societal/structural changes that will inform the ensuing analysis - governance (including democracy and decentralization), globalisation (openness and internationalisation), and the socialhuman-capital revolution. NEWPOLICYTHRESHOLDS CHILE FOR Governance (democracy and decentralization) 1.12 With the presidential election of 1989, the first since the 1973 military coup, democracy began anew inChile. After a decade or so of democracy, indicators of governance ranked Chile among the top performers in Latin America, and close to OECD countries (Kaufmann et al, 2003 and UNDP, 2002, 38-41). Chile scores particularly well in "rule of law" and "government effectiveness," but scores less well in terms of the quality o f democracy. 4 1.13 Relatedly, at the onset of ZE policies, Chile was a highly centralized country with weak or non-existent sub-national governments. With sweeping reforms inintergovernmental finances during the early 1990s, and with democratic elections at the municipal level, this i s no longer the case. Indeed, municipalities with elected mayors and councils now have access to significant revenue resources.l8They can pursue social welfare and economic development policies in their jurisdictions and are increasingly pressed to do so b y their citizens and civil society associations. Nonetheless, fiscal and political decentralization at the regional level remains less extensive than i s characteristic of most larger Latin American "unitary states", including Colombia and Peru, where regional governments are popularly elected and manage significant transfers on their own. 1.14 There are no full-fledged governments to manage and control Chile's diverse regions. Regional councils are elected indirectly (by the local councils of each province) and these regional councils are chaired by an Intendente (governor) appointed by the central government. While these regions do not have tax resources of their own and rely exclusively on government transfers, two of the most important incentives for the ZEs, namely investment subsidies and regional development funds, are allocated at the regional level. Chile's rather top-down approach to decentralization has managed to convey national priorities down to regional and local levels in such a way that i t has strengthened its ability to maintain a high degree of public investment cohesion, regardless of the level of government that plans or executes investment policies. Nonetheless, issues relating to horizontal harmonization of the many and varied ZE policies as well as the desirability of co-opting the enthusiasm and priorities of the private sector and civil society alike into the design and implementation of ZE policies may point to the need for reworking the governance framework for ZE policies. As this study is being completed Chile has signaled its willingness to entertain discussions on a variety of regional concerns. 1.15 Government has recently submitted to Congress constitutional and legal reform proposals that would strengthen governance and management capacity of regional governments and would increase the scope for regional development policies. Those proposals currently before Congress are summarized in Annex E. The proposed reforms are an important step forward in decentralizing the State. Those reforms would enhance coordination among central and regional governments regarding regional investment." Openness and Internationalization 1.16 Beyond the stellar economic performance alluded to inthe opening paragraph of this study, Chile has emerged as, arguably, the foremost free-trade nation. Its average tariff rate has fallen from about 30 percent in 1970 to something inthe order of 6 percent today, with the objective of eliminating all tariffs by 2015. Chile has free trade agreements (FTAs) with Canada, Mexico, Central America, South Korea, EFTA, the EU and the USA. It also has See Annex E for more details on Executive Initiatives regardingdecentralization. l9 fateofthereformsinCongressisnotclearatthispoint.Sincetheproposedgovernment initiativeshave The not been given priority, their discussion in the legislature will take place inthe ordinary period that starts in May 2004. Still, since municipal elections will take place in October 2004, it i s possible that a more in-depth discussion will only take place after the elections. 5 comprehensive "market opening agreements" with Bolivia (1993), Venezuela (1993), Columbia (1994), Ecuador (1995) and Peru (1998). In 1996 Chile became an associate member of MERCOSUR and in 1998 Chile hosted the Second Summit of the Americas in Santiago where the FTAA (Free Trade Area of the Americas) was formally launched. Overall, the Tuck School of Business Emerging Market Access Index ranks Chile second to Singapore and ahead of Taiwan, Israel, Brazil and South Korea. An enviable recordindeed. 1.17 Among other things, this progressive openness of Chile to the world i s serving to undercut the initial advantage of the free-trade zones or Zonas Francas that are a rather common feature of ZE policies. Relatedly, global openness combined with the emergence of China as a major trading nation has served to privilege the northern regions of Chile as potential gateways to the Pacific Rimand beyond. Inthis trading sense, Region Ii s no longer an "extreme" zone. SocialPolicy and Human Capital 1.18 Reference has already been made to the fact that Chile has, by Latin American standards, achieved significant socio-economic progress. As the recent study by the World Bank (May 2001) on poverty and income distribution in Chile noted, a combination of strong growth and well-directed social policies and social programs have combined to reduce the 40 percent poverty rate in half during a period of just eleven years: and reduced those living in extreme poverty to barely 4 percent of the population. Moreover, the Bank reports very significant increases in income arising from enhanced education - "completing secondary school brings a 70 percent gain in income ... while primary education produces a 30-40 percent gain" (LOC. Cit.). These results are obviously important in their own right, but they are also significant in that they resonate well with the on-going recognition that knowledge and human capital are increasingly important in terms of competitiveness and development. Inturn, this allows for additional degrees of freedom in terms of regional development. For one thing, it i s much easier to contemplate devolving more powers to regions when and where the poverty levels are already attenuated. For another, and arguably more importantly, regional development initiatives can now focus on "people prosperity" as well as "place prosperity", i.e. they can focus on "mortarboards" as well as traditional "boards and mortar." This will have dramatic implications for regional policy everywhere, Chile included. All of these developments and drivers of change will inform the ensuing analysis of the qualitative and quantitative assessment of Chile's ZE policies and even more so, the range of alternative approaches to future regional development of the Zonas Extrema. 6 CHAPTER2. CHARACTERISTICSOFTHEZUNAJ'EXT'EMAf 2.1 The role of this Chapter i s two-fold: first to place the three ZE regions within Chile's map and by comparison to the other ten regions and second, to begin isolating relevant similarities and differences among the three ZE regions. For purposes of this chapter, the term ZEs will refer to TarapacB, AysCn and Magallanes (Regions I, XI, and XII) and not to the other provinces and municipalities that officially come under the ZE umbrella. Further information on the special features of the ZEs will be found along the text, more particularly inChapter 4 andAnnex A. Figure 2-1Maps of Chile andSouthAmerica Cle:Nedby: World Bank Map Section 7 ZESININTERREGIONAL CONTEXT Geography 2.2 The regional geography of Chile i s portrayed in the left panel of Figure 2.1. The capital cities of Regions I, XI and XI1are Iquique, Coihaique, and PuntaArenas respectively. Region Ihave a second important port city, Arica, which i s also shown on the map. The metropolitan region, typically referredto as MR, i s Chile's capital region (Santiago). 2.3 The right frame of Figure 2.1 places Chile in its South American context. Regions XI and XI1share the southern tip of South America with Argentina. Peru sits atop of Region IanditsportcityTacnaofferscompetitiontoAricaandIquique. Region1'saccesstoBrazil and MERCOSUR generally, must go through Bolivia, which, in the current period at least, appears somewhat problematical as will be elaborated inlater contexts. Demography 2.4 Population wise, Region Ii s the largest of the ZEs with nearly 429,000 inhabitants (see column 1 of Table 2.1, The Zonas Extremas in Interregional Context). Magallanes follows with a population of 151,000 while Aystn has 91,000 inhabitants. The ZE total (ignoring the two provinces and municipalities outside the three regions) i s 671,000 or 4.4 percent of Chile's population. In sharp contrast, the three ZE regions account for 299,000 square kilometres, which accounts for roughly 40 percent of Chile's territory (see column 2 of Table 2.1). Not surprisingly, a simple ratio of population to land mass would indicate that the ZEs are very sparsely populated inrelation to the rest of Chile (column 4 of Table 2.1), with regions XI and XI1 possessing the lowest density ratios. Intriguingly, however, the populations of the ZE regions are anything but evenly spread over their respective territories. From column 3, Regions Iand XI1are highly urbanized, indeed remarkably so with ratios of 94.1 percent and 92.6 percent respectively, not far off the 96.9 urbanization ratio for the MR region. Aystn i s in the middle group interms of urbanization at just over 80 percent (column 3 of Table 2.1). 8 -r " .p L S M C.l c1 CHAPTER3. THEINSTRUMENTSANDCOSTSOFZONASEXT'EMAAS POLICIES 3.1 Policies are defined as much, if not more, b y their instruments as by their objectives. The policies related to the ZEs are no exception. A number of laws, regulations and programs discriminate in favor of ZEs. These instruments fall into two broad categories - fiscal (both tax and expenditure) andor regulatory incentives targeted at private enterprises on the one hand and intergovernmental transfers and programs related to the provision of regional/municipal public goods, services and investment, on the other. The former category aims at lowering the operating costs or enhancing the revenues of private enterprises located inZEs, which inturn, will encourage the creation and development of such enterprises. The latter attempts to ensure that the levels of public goods and services in the ZEs are at least as high as, if not higher than, those in the rest of the country. This will also serve to attract or retain enterprises and people. Unlike the fiscal incentives, which tend to be stand-alone programs designed specifically for the ZEs, the programs aimed at the allocation of public goods and services tend to be national programs that embody generous ZE preferences. The role of this Chapter 1s to describe and to attempt to estimate the costs of these two classes of instruments. 3.2 A further introductory comment i s in order. The official reported numbers for the costs of the various instruments are gross costs. These will exaggerate the true revenue costs to the treasury, at least for tax exemptions. The true or net cost for a specific instruments/exemption i s the difference between the taxes that would be collected in the absence of the tax exemption inquestion and the taxes that are actually collected. The official or gross numbers assume that economic activity would be the same in the absence of tax exemptions. In general, this i s an inappropriate assumption, given that the very rationale for tax exemptions i s to increase economic activity. 2oInother words, in the absence of these tax exemptions, the level of economic activity and, therefore, the tax bases, might be lower, so that the true "loss" to the treasury i s lower than the reported (gross) figure. Indeed, depending on the elasticity of the tax bases to changes in tax rates, a decrease in tax rates could even increase tax revenues. FISCAL INCENTIVES FORPRIVATEENTERPRISES 3.3 Table 3.1 presents a summary of the various fiscal incentives currently in place in the Zonas Extremus. The table includes the relevant laws/programs, the dates when these measures became effective and a brief description of the specific incentives applicable for each of the ZE territories. The analysis of the various instruments and their costs begins with the incentives associated with the Zonas Fruncas (free-trade zones). 20This might be true for the national level butnot for the regional -- inthe extreme case there would only be enterprise reallocations. 10 Table 3.1 Summary of ExistingBenefitsby Province/ Region AREA LEGISLATION MAIN BENEFITS Law Year hvestment Tax Credit (20 percent to 40 Arica Law I(No. 19,420) 1995 ,ercent), Exports Centres, Zero Tariff, Arica Law I1(No. 19,669) 2003 hdustrialDuty-free Zone, Labor Subsidy Arica Duty-free Zone Law (DFL34 1) 1975 117 percent); Investments Discount (20 Wage Subsidy (DL889) 1975 )ercent), Duty Free Airport, Purchasesby Development Fund (DFLNo. 15) 1982 Mandate, De-earmarkingReal Estate Purchases. Arica Law I(No. 19,420) 1995 Duty Free Airport, Industrial and Iquique Arica Law I1(No. 19,669) 2003 Duty-free Zone Law (DFL341) 1975 Zommercial Duty-free Zone, Labor Wage Subsidv (DL889) 1975 Subsidy. Tocopilla IndustrialMining Duty-free Zone Industrial Duty-free zone for mining (Law No. 19,709) 2002 supplier activities. Tax exemption, income tax exemption on Easter Island Easter Law (No. 16,441) 1966 goods located inEaster Island, VAT zxemption on internal sales, Seal and Stamps Tax Exemption, Fuel Subsidy. Austral Law (Law No. 19,606) Tax Credit on Investment (20 percent-40 1999 percent), Labor Subsidy, Tax concessions ChiloC and Wage Subsi.dy (DL889) 1975 on fiscal goods; Labor Discount (17 Palena Development Fund(DFL No. 15) FirstLady Fellowships (Law No. 1982 percent), Investments Discount (20 18,681) 1988 percent), Transportation and food and board fellowshim for Door students. Austral Law (Law No. 19,606) Tax Credit on Investment (20 percent-40 Wage Subsidy (DL889) 1999 percent), Labor Subsidy, Tax concessions AysCn Development Fund(DFL No. 15) 1975 on fiscal goods; Labor Discount (17 FirstLady Fellowships (Law No. 1982 percent), Investments Discount (20 18,681) 1988 percent), Transportation and food and board fellowships for poor students. Tax Credit on Investment (20 percent-40 Austral Law (Law No. 19,606) percent), Labor Subsidy, Tax concessions Wage Subsidy (DL889) 1999 on fiscal goods; Labor Discount (17 Development Fund(DFLNo. 15) 1975 percent), Investments Discount (20 percent), Commercial Duty-free Zone in Magallanes Punta Arenas Duty-free Zone 1982 Punta Arenas, Transportation and food and and Antktica (DFL341) 1975 board fellowships for poor students, Chilena Navarino Law (No. 18,392) 1985 Tierra del Fuego Law (No. 19,149) 1992 Development Fundwith Tax for FONDEMA (Law No. 19,275) 1993 Exploitation Rights, Navarino and Tierra FirstLady Fellowships (Law No. 1988 del Fuego preferential system 18,681) (Companies and people duty-free zone, supplementary global exemption, sales discount outside the region). Source: Ministry of Finance,Chile "Terms of Referencefor AssessingandReformulatingZE Policies" January 2003. 11 Free-Trade-Zone Incentives 3.4 From the relevant panels of Table 3.1, the laws that apply here are DFL 341, Ley 18.392 (Ley Navarino) and Ley 19.149 (Ley Tierra del Fuego). There are six free-trade zones inChile: commercialhndustrial zones inIquique (inRegion I) inPuntaArenas (inRegion and XII), a more generous industrial free-trade zone in Arica (in Region I),mineral zone in a Tocopilla, and general free-trade zones in the extreme south, i.e., to the south of the Strait of Magallanes (in Region XII). Enterprises located in these zones are exempted from three business taxes - customs duties, value-added taxes and corporate income taxes. 3.5 From Table 3.2, the 2001 sales for the Region IZona Franca, usually referred to as ZOFRI (Zona Franca Iquique) were: U$709 million for international sales or re-exports; US$294 million for sales to the rest of Chile; and US$329 million for sales within Region I (Le. VAT-exempt sales). Note that for goods re-exported to the rest of the world, there i s no VAT "loss," since exports are VAT exempt. For goods sold from Region Ito the rest of Chile, the purchaser has to pay the VAT and any customs duties exemptions. Thus, the VAT exemption only applies to the value of sales within Region I.Chilean residents in other regions can also purchase VAT-exempt goods (up to a pre-set value) if they do so inRegionI. 3.6 Hence, the gross cost of VAT and custom-duty exemption equals the sales of US$329 million multiplied by 20 percent (where 18 percent represents the VAT and the remaining 2 percent i s the customs-duty reduction relating to ZOFRI), for a total of US$65.8 million. This figure appears inthe "custom duties and VAT" row for Iquique and Region Iof Table 3.2, TheAggregate Costs of ZE Policies b y Region, 2001. 3.7 The comparable estimate for Region XI1 i s US$12.3 million, (reproduced from Annex 3, Gusto Fiscal Instrumentos Existentes, from p. 19 of Te`rminos De Referencia, Enero, 2003). 12 3.8 The Ministry of Finance estimated in US$33.2 million in the revenue cost to the Treasury of the corporate income tax exemption for Region I.The mission was not provided with an equivalent estimate for Region XII. The US$6.2 million for the corporate income tax entry for Region XI1in Table 3.3 i s calculated as the same percentage of US$12.3 million (for custom duties and VAT for Region XII) as US$33.2 million i s to US$65.8 million (Le., the same ratio as corporate income tax i s to custom duties and VAT for Region I). The total gross cost arising from the operations of the Zona Francas i s US$117.5 million with almost 100million of this (US$99.0 million) arisingin Iquique - Region I.Inthe fieldwork we were informed that the administrative costs of overseeing the Zonas Francas were substantial. Since this does not fall into the category of "fiscal incentives for private enterprises" (Le. panel A of Table 3.3), it was not included in the Table 3.3 estimates of the Zonas Francas costs. However, this would be recorded inthe later section on civil service expenditures. 3.9 From Table 3.2, the 2001 sales for the Region IZona Franca, usually referred to as ZOFRI (Zona Franca Iquique) were: U$709 million for international sales or re-exports; US$294 million for sales to the rest of Chile; and US$329 million for sales within Region I (Le. VAT-exempt sales). Note that for goods re-exported to the rest of the world, there i s no VAT "loss," since exports are VAT exempt. For goods sold from Region Ito the rest of Chile, the purchaser has to pay the VAT and any customs duties exemptions. Thus, the VAT exemption only applies to the value of sales within Region I.Chilean residents in other regions can also purchase VAT-exempt goods (up to a pre-set value) if they do so inRegion I. 3.10 Hence, the gross cost of VAT and custom-duty exemption equals the sales of US$329 million multiplied by 20 percent (where 18 percent represents the VAT and the remaining 2 percent i s the customs-duty reduction relating to ZOFRI), for a total of US$65.8 million. This figure appears inthe "custom duties and VAT" row for Iquique and Region Iof Table 3.2, TheAggregate Costs of ZE Policies b y Region, 2001. 3.11 The comparable estimate for Region XI1 i s US$12.3 million, (reproduced from Annex 3, Gasto Fiscal Instrumentos Existentes, from p. 19 of Te`rminos De Referencia, Enero, 2003). 3.12 The Ministry of Finance estimated in US$33.2 million in the revenue cost to the Treasury of the corporate income tax exemption for Region I.The mission was not provided with an equivalent estimate for Region XII. The US$6.2 million for the corporate income tax entry for Region XI1in Table 3.3 i s calculated as the same percentage of US$12.3 million (for custom duties and VAT for Region XII) as US$33.2 million i s to US65.8 million (Le., the same ratio as corporate income tax i s to custom duties and VAT for Region I). The total gross cost arising from the operations of the Zona Francas i s US$117.5 million with almost 100 million of this (US$99.0 million) arising in Iquique - Region I.In the fieldwork we were informed that the administrative costs of overseeing the Zonas Francas were substantial. Since this does not fall into the category of "fiscal incentives for private enterprises" (i.e. panel A of Table 3.3), it was not included in the Table 3.3 estimates of the Zonas Francas costs. However, this would be recorded inthe later section on civil service expenditures. 14 Table 3.3 The Aggregate Costs of ZEs Policies, by Region, 2001in US$millions Arica Iquique Region1 and Region Region Zona ZEs Palena XI XI1 Austral A -Fiscal incentives for private enterprises 1.FreeTrade Zones a) Custom duties and VAT'?' 65.8 65.8 12.3 12.3 78.1 b) Corporate income tax3 33.2 33.2 6.2 6.2 39.4 2. Wage subsidies 8.8 16.8 25.6 12.5 6.2 12.0 30.8 56.4 3. Investment tax credit 7.3 7.3 12.0 12.0 19.3 4. Investment subsidy and FONDEMA 0.75 0.1 0.6 8.8 9.6 10.3 5. Custom Duties and Sales Subsidy 5.9 5.9 5.9 Total Costs of Fiscal Instruments 16.1 115.8 132.6 12.7 6.8 57.3 76.8 209.4 B Preferential treatment for - public expenditures 1.Current social expenditures 33.0 19.0 22.0 41.0 74.0 2. Investment expenditures 37.0 50.0 49.0 99.0 136.0 3. Miscellaneous4 0.9 1.8 0.2 0.4 0.5 2.4 Total Costs of Public Expenditures 71.8 NA 69.2 71.4 140.5 212.4 C -Aggregate cost of ZE policies (C=A+B) 204.4 12.7 76.0 128.7 217.4 421.8 D Per capita costsof ZE - policies 504.6 788.6 804.9 637.7 Notes: 1,2. This is 20 percent (VAT of 18 percent and customs preference of 2 percent) applied to VAT exempt sales of ZOFRI, which equal US$329millions for 2001. 3. Estimate of Region XI1i s calculated as a percentage of US$12.3million (for custom duties and V A T for Region XII) as US$33.2million is to US$65.8million(Le. the same ratio as corporate income tax is to custom duties and VAT for Region I). 4. This includes the combined costs of special CORFO for Investment inRegion Iand the Transportation Subsidy. Source: Ministry of Finance. Wage Subsidies(DL 889) 3.13 All ZE enterprises are entitled to a wage subsidy of 17 percent of wages, with a ceiling of 25,024 pesos per month (about US$38.0) per worker. This implies that the wage subsidy is equal to 17.0 percent for wages less than 147,000 pesos per month (about US$224.0), and a declining percentage for higher wages. For example, for a salary of 300,000 pesos (about US$456.0) the subsidy would represent 8.3 percent of the salary. This wage subsidy benefits all private enterprises, except those in mining, finance and personal services. Moreover, and as we were frequently told, it i s a user-friendly subsidy - all that an enterprise needs to do in order to be eligible for the subsidy i s to produce up-to-date social security contributions. 15 3.14 The estimates of the cost of the wage subsidy also come from Annex 3 of the Terms of Reference. Expressed in US$ millions, for 2001 these costs are 8.8 for Arica; 16.8 for Iquique (and, therefore, 25.6 for Region I); 6.2 for Region XI; and 12.0 for Region XII, all of which appear in Table 3.3 in the "Wage Subsidies" row. Note that, for this instrument, data also exist for the provinces of ChiloC and Palena - wage subsidies amount to US$12.5 million for these provinces. This figure appears in Table 3.3 under the ChiloC and Palena column. Unfortunately, adequate data are not available on province basis for most of the instruments in Table 3.3. Nonetheless, it seemed appropriate to include inthe table those province estimates that were available. 3.15 Table 3.4 presents selected time series data in millions of US dollars for the wage subsidy for Region Iand Region XII. The 2001 data in this table for Arica, Iquique and Region Icoincide with the relevant entries inTable 3.3. The US$11.6 million estimate for the cost of wage subsidies in Table 3.4 i s slightly lower than the 12.0 entry in Table 3.3 (reflecting perhaps the different source for the data), but they are close enough that the difference might be as simple as the value of the exchange rate used for converting pesos to dollars. The temporal behaviour of the wage subsidy data in Table 3.4 will be relied upon to inform the Chapter 4 assessment of benefits arising from the ZE policies, including the fact that Iquique seems to have faired much better than Arica. In the present context, Table 3.4 lends credence to the data in Table 3.3 for wage subsidies since they come from different sources, Year Africa Iquique RegionI RegionXI1 1990 2.8 3.O 5.8 1991 3.1 3.5 6.6 1992 3.5 4.1 7.6 1993 3.9 5.6 9.5 1994 5.2 8.0 13.2 1995 6.0 8.5 14.5 1996 6.8 10.8 17.6 1997 7.5 12.3 19.8 1998 7.6 14.3 21.9 11.3 1999 7.9 14.0 21.8 11.8 2000 8.5 14.4 22.9 . 10.9 2001 8.8 16.4 25.2 11.6 2002 8.7 15.1 23.8 Exchange rate=634.9 Source: Ministry of Finance, Chile "Terms of Reference for Assessing and Reformulating ZE Policies" January 2003. InvestmentTax Credits 3.16 Enterprises located in the province of Arica in Region I(Ley 19.420),in Regions XI and XII, and in the province of Palena in Region X (Ley 19.606 also referred to as Ley Austral) are allowed to deduct between 10 percent and 40 percent of their investments from 16 their corporate income tax. This means that only enterprises actually making a profit, and therefore paying corporate income taxes, can benefit from this tax incentive. The credit has a very long carry-forward provision - up until 2030, according to the regulations. The credit i s limited to investments "for the production of goods and services", which i s interpreted to exclude agriculture, mining and commerce. The deduction schedule i s rather complicated and varies (from 10 percent to 40 percent) with the type of investment (vehicles vs. construction, for instance) and with the amount of investment (below or above 200,000 UTM or about US$9 million). 3.17 The estimated cost to the Treasury of the investment tax credit i s US$19.3 million (Table 3.7, row A3), with US$7.3 million attributed to Arica (Region I) and US$12.0 million to Region XII. (Again, these are data from the Ministry of Finance, from Annex 3 of the Terms of Reference). In the next chapter, the data on the operations of free-trade zone in Arica indicate that there has been a recent substantial increase in the number of industrial establishments in Arica. Presumably these relate, in part at least, to the recent enhancements embodied in Arica Law 11 in 2001. In turn, this raises the possibility that we are underestimating the fiscal cost (or soon-to-be fiscal cost) in Arica in terms of this investment tax credit. Investment Subsidies (DFL 15) 3.18 Investments in the ZEs are eligible for a subsidy o f 20 percent under provisions embodied in DFL 15. On the recommendation of the Ministry of Finance, Parliament allocates a given amount annually for each ZE region to finance this investment subsidy. In addition, a special fund, FONDEMA, for the development of Region XI1has been created by Ley 19.275. FONDEMA i s financed by 25 percent of royalties (100 percent since Austral Law in 1999) paid on gas and oil mining in Region XI1 - a sort of earmarked tax. Both sources of income appear to be managed inthe same manner. 3.19 These are not open-ended subsidies. Enterprises that have undertaken investments during the year may apply for the subsidy. A committee, consisting largely of elected members of the regional council and relying on more or less explicit criteria, selects the enterprises or more precisely the projects that will benefit from the subsidy. The approval ratio (ratio of projects approved and subsidized to projects submitted) i s low, and rarely exceeds 20 percent. 3.20 The cost of this investment subsidy i s reported to be US$10.3 million in 2001, with FONDEMA contributing US$8.3 million (Annex 3, Terms o f Reference). The allocation of costs across the ZEs appears inrow Table 3.3, row A4. 3.21 Though the investment subsidy i s trying to address the limitations of the tax incentive on investment expenditures, the implementation rules deny the companies that benefit. The ex-post decision on the subsidy, combined with the low subsidy rate of 20 percent, reduces the ex-ante expected subsidy to 4 percent of the investment. Taking risk aversion of companies into consideration, it i s unlikely, that new companies invest the effort and apply for the subsidy. The subsidy i s inefficient and not transparent. 17 Sales Subsidies 3.22 Under the provision of Ley Nuvurino (Ley 18.392), four small zones inthe provinces of Tierra de Fuego and Magallanes in Region XI1 can be considered as "super free-trade zones". They are Navarino (2,300 inhabitants), Timaukel (400 inhabitants), Porvenir (5,400 inhabitants), and Primavera (1,000 inhabitants). Enterprises located in these areas are practically entirely tax-exempt. In addition, the Treasury pays a subsidy equal to 20 percent of the sales of these enterprises. This important subsidy i s subject to two conditions: that sales be exported out of Region XII, and that the local content (local labor and inputs from the region) amount to at least 25 percent of the output. 3.23 The amount of this subsidy i s reported to be equal to US$5.9 million in 2001, and we were informed on the field trip to Region XI1that it has been growing rapidly and i s likely to continue to do so (Table 3.3, row A5). 3.24 While this completes the estimates of the costs of those ZE policies associated with fiscal incentives for private enterprises, we defer further discussion of the Table 3.3 aggregates until after we have added in the costs related to the preferential treatment for the ZEs arising from the manner in which public expenditures are allocated across regions. B y way o f an analytical, as distinct from a statistical, conclusion to this section, we refer the reader to Table 3.5, which summarizes some key features of these five fiscal instruments. Table 3.5 KeyFeaturesof ZEs Policy Instruments Free-tradeZones No No Yes No Wages Subsidy Yes No Yes Yes Investmenttax credit Yes No Yes Yes InvestmentSubsidy Yes Yes No No Sales subsidy No No Yes No PREFERENTIAL ZE ALLOCATIONSOF PUBLIC EXPENDITURE TRANSFERS 62. The report now turns the focus to the system of intergovernmental transfers on the one hand and to the regional/allocation of the funds for the provision of public goods, services and investment on the other. The objective here i s to isolate and, hopefully, quantify those transferdprograms that favor the ZEs. An alternative way of describing the role o f this section i s that the focus i s on ascertaining whether explicitly national transferdprograms for allocating money and services to the regions end up favoring selected regions and, in particular, the ZE regions. The analysis begins with the transferdprograms relating to financing regional investment, to then be followed by the determinants of current social expenditures. 18 Regional Investment Financing 3.25 The Regional Investment Programs include four sources of funds: The National Regional Development Fund (FNDR), which allocates investment funds to the regions based on two criteria - socio-economic indicators and the "particular territorial situation of each region". Both tend to favor the ZEs; Regional Assignment Sectoral Investment program (ISAR), which funds "projects" in the regions. Often this project-based financing means that lower populationregions like the ZEs will benefit inper capita terms; Local Assignment Regional Investment (IRAL);and Programming Agreements. Neither of the last two components would appear to have any built-in bias toward the ZEs. 3.26 Often these four funding sources are referred to as the "Regional-Decision Investments" since they embody a degree of regional input in the decision processes. These components account for 46 percent of all public investment. The remainder (54 percent in 2001) comes from investment in the regions undertaken directly by the Ministries such as public works, education, health, housing, etc. Current SocialExpenditures 3.27 Social expenditures include the categories of personnel, goods and services, welfare, and the like. The allocations across regions are based on three criteria. The first relates to the provision of minimumgoods, services and institutions across regions. These could benefit the ZEs preferentially in dollar terms because their remoteness means that it will cost more to deliver this minimumlevel and/or because the remoteness of the ZEs means that institutions will tend to be of a full-service nature since they do not have the ability to draw on nearby institutions for needed services. A second criterion i s citizen demand for services, e.g., vouchers for education. To the extent that this category i s capitation driven, there would not be a ZE preference. The third category i s transfers and subsidies, with the allocation criteria related to poverty, dependency, potable water, and the like. The distribution of these allotments across regions typically ends up favoring remote areas and, therefore, the ZEs. 3.28 Principal determinants of municipal financing include the creation of the Municipal Common Fund, which amounts to a municipal revenue-sharing pool where rich municipalities contribute to the pool and poor municipalities draw upon it. This concept will resurface inthe later chapter focusing on alternative approaches to regional/municipal financing. The report does not include municipal financing inthis chapter. Cost Estimates 3.29 Table 3.6 (Preferential Public Expenditures on ZEs, 2001) presents program expenditures for the ZEs and for Chile as a whole. From row A.l, it i s evident that all three regions receive preferential treatment with respect to current social expenditures. For 19 example, Region XI1 receives US$536.0 per capita compared to the all-Chile average of US$404.0. Row A.2 converts this to an index, revealing that Regions I, and XI1receive 20 XI percent, 48 percent and 33 percent more than the national average respectively. 3.30 The comparable data on public investment embody much greater preferences. From row B.2, Regions I, XI and XI1receive investment expenditures 85 percent, 478 percent and 285 percent above the national average respectively. Table 3.6 PreferentialPublicExpenditureson ZEs 2001 Chile RegionI RegionXI RegionXI1 A. Current SocialExpenditures 1. US $ per capita 404 484 599 536 2 Index of Row A.1. 100 120 148 133 3. PreferentialSpending($ P.c.) ' 80 195 132 4. PreferentialSpending(US$ million) * 0 33 19 22 B. InvestmentExpenditures 1. US $ percapita 108 200 624 416 2. Index of Row B.l 100 185 578 385 3. PreferentialSpending($p.c.) 92 516 308 4. PreferentialSpending(US $ mill) 37 50 49 C. Population(`000) 405.2 96.4 159.9 1) Calculatedfromrow A.l (Region Iequals 484 - 404 or US$80 P.c.). 2) Equals row A.3 multipliedby population(from row C). 3) Calculatedfrom row B.l (Le. 92 for Region Iequals 200 minus 108). 4) Equalsrow B.3 multipliedby the population(row C). Source: MIDEPLANNotes. 3.31 Rows 3 and 4 of panels A and B are designed to convert these preferences into absolute US$ values so that they can be entered into Table 3.7. Rows A.3 and B.3 present the preferential excess spending expressed in per capita US$. For example, the US$195.0 figure inrow A.3 for Regions XIequals the US$599.0figure inrow A.1minus the all-Chile average of US$404.0 (Le., 599-404=195). Rows A.4 and B.4 are calculated b y multiplying the A.3 and B.4 per capita figures by the population data in row C. This generates preferential ZE spending estimates in terms of U S dollars, which are then entered into panel B of Table 3.7. Thus, in terms of current social expenditures in panel B of Table 3.7, Region Ireceives an allocation that i s US$33 million more than what it would receive were it treated like the "average" region. Comparable nominal dollar figures are US$19.0 and US$22.0 million for Regions XI and XII. In terms of public investment allocations, the preferences are larger, especially for Regions XI and XI1 - US$37, 50, and 49 million respectively for the three regions. 3.32 It is most important to note that these preferential or excess transfers are in "nominal" dollars; they are not corrected for regional cost-of-living differences presented in Table 3.6 above. The report elaborates on this issue in the context of the following important detour on the civil service regional wage bonus system in Chile. 20 Table 3.7 Cost of LivingIndex, 2001 Region Index MetropolitanRegion 100 RegionI 102 RegionI1 102 RegionXI 120 RegionXI1 125 Source: Ministry of Finance. CivilServants and the Wage Bonus 3.33 The Table 3.6 data relating to current social expenditures subsume as a component the two-fold effect of regional wage policy: i)that the ZEs have a larger number of civil servants per capita and ii)they are paid a larger salary if they reside in the ZEs. This merits some analytical and statistical elaboration. 3.34 Table 3.8 (Number of Civil Servants Per Capita, 2002, by Region) reveals that, on average, the Zonas Extremas have 73 percent more civil servants per capita than i s true for Chile as a whole. AysCn and Magallanes both have per capita civil servants more than double the national average - 149 percent and 123 percent above, respectively. Region Ihas 36 percent more public sector employees per capita than the national average. Number Index RegionITarapach 13 136 Regi6nXI AysBn 24 249 Regi6nXI1Magallanes 22 223 Zonas Extremas 17 173 Source: World Bank estimates, calculated from data o f the Budget Office o f the Ministryof Finance. 3.35 Table 3.9 focuses on the 2002 territorial wage bonus (Asignacidn de Zonas) for civil servants. Rows 1and 2 of Table 3.8 reveal that all civil servants, no matter where they reside, are entitled to the same basic wage (A) and standard allowance (B). The third row details the so-called "zone bonus" - 10 percent on average for Chile, 40 percent for Region I,60 percent for Region XI and 70 percent for Region XII. Row 4 totals the absolute wage scale by ZE region while row 5 presents the percentage or relative increase over the Chilean average - 20 percent, 33 percent, and 40 percent for Regions I, XI andXI1respectively. 21 Table 3.9 Civil Servants Wage Bonus by Region, 2002 Region Chile Tarapacii Aydn Magallanes Basic wage (A) 100 100 100 100 Standardallowance (B)a 40 40 40 40 Zonebonus (average) (C) 10 40 60 70 Total (D=A+B+C) 150 180 200 210 Zone bonus (E=(D`-150)/150) 0 percent 20 percent 33 percent 40 percent Notes: a The standard allowance canbe muchhigher for certain civil servants, such as thejudges. b The numbers givenare averagesfor the regions; for certain communes of these regions, the differentialcanbe much greater; the maximum zone bonus in Magallanes region i s reported to be 190, which would translate in a zone bonus of 120 percent relativeto the Chile average. Source: World Bank estimates, calculated from data of the Budget Office of the Ministry of Finance. 3.36 Table 3.9 can be viewed as the "price effect" and Table 3.8 as the "quantity effect" of Chile's civil service wage policy for regions. The product of these two effects will yield the "full" preferential effect of civil servant employment inthe ZEs. InTarapaca or Region I, for instance, the price effect (1.2 from row 5 of Table 3.9) multiplied by the quantity effect (1.4 from Table 3.8) equals 1.6, or a 63 percent all-in preferential per capita treatment. Comparable preferences for Region XI and Region XI1 are much larger - 231 percent for XI and 212 percent for XII. Yet preferential social spending inTarapaca inTable 3.9 i s only 120 or 20 percent higher than the Chilean average. This difference i s explained in part by the fact that civil servants wages are only a part of the data makingup the current social expenditure category. This study shall have occasion to return to the civil servant bonus issue later in the Report. 3.37 A final observation i s in order. There i s no reference in Tables 3.6, 3.8 and 3.9 to differential costs of living among the three ZE regions and between them and the rest of Chile. From Table 3.7, the cost of living index for the ZE regions for 2001 was estimated to be 102, 120, and 125 for Regions I, XI and XI1respectively. To highlight the significance of these differentials, consider again wage bonus data in Table 3.9. The 20 percent bonus for Tarapaca (Region I) i s reduced to roughly 18 percent if one were to correct it for the cost of living. However, the 33 percent bonus for Region XI (Ayskn) i s reduced to something like 13 percent when its 20 percent higher cost of living i s factored in. Even Magallanes with its nominal 40 percent wage bonus i s likely to fall beneath the 20 percent bonus for Tarapaca when corrected for cost-of-living differences. One could make a compelling case that Table 3.9 and panel B of Table 3.6 should be presented in real terms, i.e., they should incorporate cost of living differences. Readers should remain aware of this when assessing the costs and benefits of ZE policies. Miscellaneous Expenditures 3.38 B y way of completing the ZE preferential treatment with respect to public expenditures, two final programs merit mention. The first of these i s the transport subsidy (Subsidio al Transporte Regional) and the other i s the investment program sponsored by CORFO, largely in Arica. Given the huge distances in Chile and the ruggedness of the terrain, especially inthe south, one would expect that ZE transportation subsidies would loom 22 large. Infact, they are surprisingly small. Indeed, the combined value of these two programs i s only US$2.4 millions. For purposes of Table 3.6, the value of the COW0 programs in Arica i s estimated to be US$0.9 million and the remainder (US$1.5 million) i s allocated across regions on an equal-per-capital basis. THEAGGREGATECOSTSOFZEPOLICIES 3.39 Table 3.3 summarizes the various costs associated with ZE incentives (panel A) and with preferential allocation treatment (panel B) by region and by instrument. These are the best estimates of the gross costs of these ZE policies. To the extent that these policies have been successful in stimulating growth and, more particularly, revenues above and beyond what they would otherwise have been,*l then the data in panel A will over-estimate the true or net costs. This report does not attempt to assess the magnitude of the net costs. 3.40 The aggregate or overall cost across these three regions i s estimated to be US$421.8 million (row C). This total includes the US$209.4 million arising from the panel A: Fiscal Incentives and the roughly equal US$212.4 million arising from preferential ZE allocations from national public expenditure programs. 3.41 Turningto the costs by region, the panel B data relating to the total costs associated with special treatment for the ZEs are roughly equal across all regions - 71.8, 69.2 and 71.4 million U S dollars for I,XI and XI1 respectively. In sharp contrast, the fiscal incentives targeted on private enterprises (panel A) cost the Treasury muchmore for Region I(US$132.6 million) than for Region XI1 (US$57.3 million) and especially for Region XI (US$6.8 million). 3.42 However, the story i s quite different on a per capita basis. Fromrow D of Table 3.3, the per-capita cost in U S dollars of ZE policies for Region Ii s US$504.6. This rises to US$788.6 for Region XI and i s higher still in Region XI1- US$804.9. Although not shown in Table 3.3, the per capita costs for the fiscal instruments (panel A) is US$327.3, US$70.5 and US$358.6, Le., roughly equal for Regions Iand XII, with Region XI well back. This follows in large measure from the fact that Region XI does not have a free trade zone. The per capita costs to the Treasury for preferential regional expenditure allocations are US$177.2 for Region I, US$718.0 for Region XI and US$446.3 for Region XII. Here, Ayskn or Region XI1makes upfor its lesser per capita shareinthe panelA data. 3.43 Table 3.3 also presents some data on the sub-regional allocation of costs. These are, by necessity, incomplete: for example, the panel A totals for Arica and Iquique sum i s slightly less than the Region Itotal. This partial breakdown for Region Iwas included principally as backdrop for assessing the ZE benefits in relation to the growth of Arica and Iquique in the following chapter. It would obviously have been desirable to include estimates for the other provinces/communes that are part of the ZEs (as we were able to do for Chilo6 and Palena for two entries inPanel A), but the data were simply not available. *'Determining the causal or marginal effects of the ZE policies on population development, standard of life or economic activity is not applicable with the precise (fiscal) point or the limiteddata that was at the report's disposal considering the complexity of a regional population model or empirical analysis. Thus, there i s evidence of close correlation, but there i s not enough solid information to affirm there is direct causality. 23 3.44 By way of a final observation on the Table 3.3 aggregate costs, it would be nice to be able to render ajudgment on whether the aggregate per capita cost of just under US$638 i s a large number. One can find sub-regional governments with similar populations as the three regions that do receive more in terms of preferential fiscal transfers. For example, the Canadian province of Newfoundland falls in this category, with more than US$lO,OOO per person in preferential fiscal transfers. On the other hand, US$638 per capita i s presumably large if the comparison i s limited to Latin America. An alternative way of addressing this question i s to compare the cost to the benefits received. Assessing the benefits of the ZE policies i s the role of Chapter 4. 24 CHAPTER4. EVALUATION OFZUNASEXTX'EMAS POLICIES DIFFERENCES AMONG THE ZES. 4.1 Further characteristics of ZEs will serve this chapter to emphasize the similarities and differences not only among the regions that comprise the ZEs, but also between the ZEs and the remainingregions of Chile. 4.2 The regions that comprise the ZEs do have some common features. They are extreme in the sense of being far from the economic, political and geographic centre of Chile. All three share hostile environments - sand in the north and ice in the south, with the percentage of usable land significantly lower than in the rest of the country. Moreover, as noted in the introductory chapter, their most important shared features are historical and political, indeedmilitary. Inaddition, they remain geo-politically important. Incomes 4.3 Column 5 of Table 2.1 presents data on per capita regional GDPs, expressed as percentages of the Chilean average. The runaway leader here i s mineral-rich Antofagasta (Region 11) with an index of 233 and almost 6 times that of the poorest region Araucania. Region XI1 fares well in this ranking as does Region I(in second and fourth place, respectively), while AysCn i s in the middle of the pack. Data relating to household income paints a somewhat different picture. Region XI1 now has the highest average household income, with Regions Iand XI in 4th and 5th place respectively. The difference between the GDP and household income rankings is due inpart to the fact that a significant portion of the high GDP associated with the mineral-rich regions of Antofagasta and Atacama (regions I1 and 111) accrues to corporations and does not flow through to familyhousehold incomes in these regions. Social Indicators 4.4 Columns 7-10 of Table 2.1 focus on a series of social indicators relating to education, poverty, housing, and infant mortality. In general, the ZE regions score well. Region XI1 has the lowest poverty rate of all regions (10.9 percent), the fewest housing "deficits," i s tied with Region Ifor third place in terms of average years o f schooling, and has the second lowest infant mortality rate (behind leader, Region I). Ays6n ranks better than the average region in terms of infant mortality and housing, but below average in terms of education and poverty. Public Spending 4.5 Columns 11and 12of Table 2.1 present data on the regional allocations of per capita public social spending and public investment respectively. On both counts, Regions XI and XI1top the list, and for public investment, they receive more than three and five times the national average respectively. Region Ialso fares better than the national average. These allocations to the regions will receive special attention in the next chapter because they constitute part of the privileged treatment received by the ZEs 25 Exports 4.6 The final column of Table 2.1 presents data on exports by region. Admittedly, there are problems with this data set. As the notes beneath the table indicate, the exports from Regions VI, VI1 and IX are booked in neighboring regions. In addition, the 36 percent of exports from Valparaiso (Region V) presumably includes much of the exports of the Metropolitan Region (MR). Notwithstanding these concerns, it seems that the data for the ZE regions are relatively free from these sorts of problems. The export share of the ZEs i s 9.2 percent, more than double the ZE population share. 4.7 The 5.5 percent share for Region Imerits further attention. In absolute terms, this amounted to US$819 million for the year 1998. The operations of Region 1's free-trade zone or Zona Franca are excluded from this figure. Presumably, this i s because these goods are re- exported without ever having formally entered Chile per se. Nonetheless, these re-exports to the rest of the world from the free-trade zone totaled US$1.2 billion, or 50 percent above the formal Region Iexports. 4.8 By way of additional yet related information, Regions XI and XI1 have unemployment rates that are below the national average. For most of the last 20 years the unemployment rate for Region Iwas also below the national average. Since 1999, however, Region 1's unemployment rate has been slightly above the Chilean average, reflecting, among other things, the post-Asian-crisis slowdown in the operations of ZOFRI, also elaborated in Chapter 1V. Recapitulation 4.9 The picture that emerges i s that the ZEs are, in comparison to other regions, small in population, large in terms of territory, highly urbanized, on balance above average interms of regional GDP and more so with respect to household income, amongst the best performers in terms of social indicators, and the recipients of very generous allocations for social expenditures and public investment. Overall, rather enviable. 26 Cost of LivingDifferences 4.10 However, there are some very significant differences among the ZEs, and especially between Region Ion the one hand and Regions XI and XI1on the other. The most obvious i s that the ZE south i s much more isolated than ZE north. Region Imay be an extreme zone when the reference point i s Santiago, but it i s anything but extreme economically when the reference point i s South America or the Pacific Rim. 4.11 One implication of the physical isolation of the southern ZEs i s that people and goods can only be transported there by air or sea. Inturn, this i s reflected indifferential costs of living. From Table 3.7, prepared for us by the Ministry of Finance, the cost of living in Region Ii s only 2 percent higher than it i s inthe Metropolitan Region whereas it i s 20 percent and 25 percent higher in Regions XI and XI1respectively. Hence, cost-of-living with Region IisessentiallyonparwiththerestofChile,sothattherealdifferencesarebetweentheZEsin the south and the rest of Chile. 4.12 Related data from the Ministry of the Interior (SUBDERE) confirm these cost differences. For example, the cost (expressed as an index) of a kilometer of pavement i s 125 in Region I,208 in Region XI and 138 in Region XII, where the reference point is Metropolitan Region equaling 100. Another example relates to the cost of house construction per square metre-76 in Region I, 131inXI and 145 inXII, again with MR=100. 4.13 The resulting implications of these cost of living differences are very significant for the ensuing analysis. If nominal wages are not higher in the south by roughly 20 percent, workers will face pressures to migrate. Likewise, paying civil servants "isolation" or "cost-of- living" premiums will be necessary in order to attract high-calibre employees. Such premia are common in many countries with isolated territories. It also means that government transfers to these regions, which exceed the national average level of these transfers b y the cost of living differential, should not be viewed as subsidies in the normal sense of this term. The main point here i s that this cost-of-living differential between ZE south and ZE north will feature prominently inthe approach to assessingthe Zonas Extremas policies. StructuraUEconomic Differences 4.14 Table 4.1 focuses on structural differences across the ZE regions. Compared to the Chilean average, all three regions are more miningintensive-copper for Region I, gold for XI and methane for XII. Region Ihas 29 percent of its activity in the Commerce and Restaurant category, a reflection of the importance o f the commercial free-trade zone in Iquique. Fishing i s extremely important in Aysin and it i s slightly above the Chilean average in Magallanes as well. The share of Manufacturing in Region XI1 i s much higher than for Chile as a whole, while precisely the opposite i s true for Region XI. All of the ZE regions are weak in financial services. AysCn's large share o f other services reflects inpart its larger per capita complement of public servants. 27 Table 4.1 Composition of GDPfor ZEs, 2000 Chile RegionI RegionX I RegionXI1 Agriculture, Forestry and Fishing 8 4 21 9 Minerals and Oil 11 18 16 21 Manufacturing 16 16 3 24 Electricity/Gas/Water 3 2 2 1 Construction 5 5 10 4 Commercial and Restaurant 19 29 11 13 Transport and Communication 10 8 10 9 Financial Services 15 6 6 6 * Other Services* 12 12 22 13 Includes Real State, Personal Service and Public Administration Source: NE. 4.15 The leading products to be exported from Region Iare (in order of importance): copper cathodes, iodine, fishmeal, transport vehicles, rock salt, and boric acid (JICA, Table 4.1.7). The corresponding list for Region XI includes: Pacific salmon, trout, gold, hake, zinc, and wood chips. (JICA Table 4.5.6). Methanol i s far and away the principal export of Region XII, followed by seaurchin, grouper, other canned fish, andwool tops. 4.16 What i s very evident from all of this i s that these regions are very different from each other. Indeed, the structure of Region Ihas much more in common with its neighboring regions I1 and 111, both of which also have copper cathodes as their principal export, for example. With this as backdrop, we now turn to an analysis of the benefits of the ZE policies. PERFORMANCEEVALUATION CRITERIA. IMPACT OF CURRENT INSTRUMENTS ONRELEVANT ECONOMICAND SOCIAL INDICATORS 4.17 This section addresses the quantitative performance evaluation of the current instruments interms of their impact on relevant economic and social indicators. 4.18 The Terms of Reference call for a qualitative assessment of the current ZE policies. After extensive discussions, the team decided not to incorporate an econometric analysis of the effectiveness of the various policies. Instead the team determined that a statistical analysis of the data and a qualitative assessment of the pros and cons o f current instrument design would suffice. 4.19 The reasoning for this approach i s the following. Independent of the degree of success of the previous and present incentive policies for the ZEs, the Bank team i s persuaded that the present incentives require a shift from financial and fiscal incentives to indirect subsidies and structural changes in order to achieve self-sustainable regional economies. Therefore, an econometric analysis of determinants of regional growth would not only go beyond the terms o f reference but could deviate the attention from more pressing policy- making demands. Additionally, the data presently available does not lend itself to a comprehensive factor analysis. 28 4.20 In general, the report looks into three types of indicators for a successful regional policy: Population growth, selected economic activities, and socio-economic indicators. The quantitative analysis compares the development of the selected indicators over time following the introduction of the various policies. The benchmarks of these indicators are derived from the experience from other countries and regions. 4.21 Ex-ante, Zonas Extremas are defined as remote regions, lacking employment opportunities, with higher cost of living due to the unfavorable geographical and natural endowments. Thus, ex-ante, the Zonas Extremas are unattractive for the existing population causing migration. 4.22 The most prominent indicator for a successful regional policy is the demographic development. As a proxy, the report uses population growth.22The following analysis shows, that unlike most other regions and countries, ex-post, the Zonas Extremas did not experience out-migration, significant income differentials or unemployment differentials usually associated with disadvantaged regions. Thus, the overall mix of policies seems to have been effective, considering the ex-ante geographical and socio-economic constraint^.^^ PERFORMANCE EVALUATION METHOD 4.23 The evaluation of the ZE policies will consist of addressing two issues. First, what have been the benefits of ZE policies, i.e. how have the ZEs performed relative to the rest of Chile? Alternatively, this can be phrased in terms of assessing whether the broad objectives of ZE policies have been achieved. Second, and to the extent that the objectives have indeed been achieved, can this success be attributed to the mix of instruments in the ZE policy arsenal? There i s actually a third question, namely whether these same instruments, singularly and in combination, could be redeployed in ways that would have been more effective in meeting these objectives, or would have achieved similar objectives but at lesser cost. While this last issue will be dealt with in a passing fashion inthis chapter, it will feature prominently inChapter 5. HAVE ZEPOLICYOBJECTIVES BEENACHIEVED? THE 4.24 While the objectives underpinning the ZE policies have not been formally promulgated, they are nonetheless implicitly clear - as noted inthe introduction they are, inter alia, to strengthen the administration of these designated regions, to enhance the economic development of the ZE regions and to increase the standard of living of their residents, all geared toward the larger and strategic objective of increasing their population and securing their territorially integrity within Chile. This suggests that an excellent starting point for the analysis i s to focus on population growth for the ZE regions. It i s also an appropriate starting 22 Sinn, H.W.; Flaig, G.;Werding, M.;Munz, S.; Dull, N.;Hofmann,H.,EU-Erweiterungund Arbeitskrafiemigration: Wege zu einer schrittweisenAnnaherungderArbeitsmarkte,Munich 2001, if0 Beitrage zur Wirtschaftsforschung2, if0 Institutfur Wirtschaftsforschung.SamuelBentolila, Las migracionesinteriores en EspaAa, DOCUMENT0 DETRABAJO2001-07, FEDEDA. See also: htt~://www.fedea.es/hoiasl~ublicaciones.html#D~cuinentosTrdbaio de 23 Note that this report did not demonstratestatistically the effectiveness of these policies. 29 point from the perspective of data availability. Following this, focus will be directed to the operations of the Zonas Francas or free-trade-zone policies on economic activity. Unfortunately, data availability will limit this analysis largely to Region I.The remainderof this section will then address the performance of the ZEs in terms of a series of socio- economic indicators. PopulationGrowth 4.25 Table 4.2 presents population data for Region I, and XII, singly and in aggregate, XI for the last four censuses - 1970, 1982, 1992, and 2002. Since the Zonas Francas were put in place in or around the mid-l970s, the 1970 census seemed the appropriate starting point. Looking first at the aggregate level (the sum of Regions I,XI and XII, namely the last column), ZE population growth has exceededthe all-Chilean growth over each census period, with the overall 2002/1970 ZE growth rates of 113 percent well in excess of the comparable Chilean growth rate of 70 percent.24(Note that we are expressing the 2002/1970 ratio 2.13 in terms of its growth-rate equivalent, namely 113 percent.). As a share of Chilean population, the ZEs accountedfor 3.55 percent in 1970, rising to 4.44 percent in 2002 (final column). Table 4.2 ZE PopulationGrowth Year ITaraDach XI AvsCn XI1Magallanes CHILE ZEs 1970 POP 175,208 50,300 89,443 8,884,768 314,951 Dercent 1.97 0.57 1.01 100.00 3.54 1982 POP 275,144 66,361 131,914 11,329,736 473,419 percent 2.43 0.59 1.16 100.00 4.18 1992 POP 339,579 80,501 143,198 13,348,401 563,278 percent 2.54 0.60 1.07 100.00 4.22 2002 POP 428,594 91,492 150,826 15,116,435 670,912 Dercent 2.84 0.61 1.oo 100.00 4.44 Growth Rates 198211970 1.57 1.32 1.47 1.28 1.50 199211982 1.23 1.21 1.09 1.18 1.19 200211992 1.26 1.14 1.05 1.13 1.19 200211970 2.45 1.82 1.69 1.70 2.13 Source: EVE, Census 1970, 1982, 1992,2002. ~~ ___ 24This report did not demonstrate statistically the alternative of these regions growingbefore the policies were implemented. 30 4.26 At the specific region level, however, the story is quite different. Tarapaci, or Region I, i s driving the aggregate results. Over the 1970-2002 period, its population has increased by 145 percent and its share of Chile's population has increased from 1.97 percent in 1970 to 2.84 percent in 2002. In contrast, Region XI1 (Magallanes) has essentially maintained its population share over this period - 1.01percent of Chile's population in 1970 and 1.OO percent in 2002. Intriguingly, these two end-points mask a sharp populationincrease for Region XI1 over the 1970-1982 period (47 percent), so much so that its percentage of Chile's population increased to 1.16 percent. Over the last twenty years, however, this has fallen back to 1.00, as already noted. Region XI (AysCn) has experienced population growth slightly in excess of the Chilean average over each of the periods, and its share of Chile's population has risen steadily, albeit slowly, from 0.57 percent to 0.61 percent. 4.27 Some perspective i s needed here and this i s provided by Table 4.3 which contains the populations of all regions in 1970 and in 1992 as well as the regions' growth rates over this period. The Regions Ito XI1plus MR (Santiago or the Metropolitan Region) and Chile itself are arranged in Table 4.3 in order of their growth rates since 1970. Tarapaci or Region Inotonlytopsthelist, butalsohaveagrowthratehalfagainaslargeassecondplace Antofagasta (145 percent vs. 95 percent). AysCn comes in fourth place. Region XI1with a ratio of 168 comes just behind the-all Chile average of 1.70 and in sixth place among the regions. If one removes Magallanes' fellow ZE regions from the comparison, then Region XII, the slowest growing of the ZE regions, is surpassedonly by the Metropolitan region and ). Regions I1and IV. 4.28 Since population concerns were surely among the overriding objectives of the ZE policies, Table 4.2 and 4.3 provide unmistakable signals that the intended objectives have been achieved on this score, and spectacularly so for Region I.Note that this i s a high standard, namely ensuring that the share of the region in the country's population (rather than absolute population) i s at least maintained.25 4.29 Population growth as an indicator i s very informative in another sense as well. Since these regions are extreme (in ways described earlier), population increases presumably signal that economic and socio-economic conditions within them must have been sufficiently attractive to offset these evident disadvantages, or why would Regions XI and XI1retain their population shares, and why would Region Ihave had such dramatic population growth seven of the ten non-ZE regions did not hold their own population-wise? Part of the answer as it relates to Region Ihas to do with the operations of its free-trade zone. 26 Free-Trade Zones: Region IExperience 4.30 Table 3.2 presents data relating to the operations of ZOFRI (Zona Franca Iquique), the organization that manages the operations of the Region 1's Zona Franca. The upper panel of the table records the number and types of enterprises associated with the free-trade zone 25 There is not enough solid information to affirm there i s direct causality between the policies and the observed results. 26However, it i s important to keep in mindthat Region Iwas not an Extreme Zone "in the strict sense" in the first place. 31 while the lower panel presents sales figures classifiedby destination - International, Region I, and the Rest of Chile. 4.31 The analysis of Table 3.2 begins by directing attention to the operations of the commercial free-trade zone in Iquique (rows 3 and 4 of Panel A, where the former relates to the shops that are housed in the huge public mall and the latter relate to independent retailers operating outside the formal mall area). The story here i s one of extremely rapid growth of the number of enterprises until the mid-l990s, with a marked decline thereafter, i.e. the mall enterprises (A.3) increase from 71 in 1976 to over 1,300 inthe 1995-98 era, and then taper off to under 1000 enterprises in 2002. This same pattern i s revealed in the sales figures in the lower panel - US$1.3 billion in 1991, rising to over US$2.0 billion in 1997-98, then falling to US$1.2 billion in 2002. 4.32 There are several obvious explanations for this tapering off of enterprises and of sales related to the commercial free-trade zone after 1998.27 Perhaps the most important of these i s the dramatic decrease in Chile's import duties - from an average 35 percent in the early 1980s to roughly 6 percent today. This implies that the advantage associated with the duty-free zone has fallen apace. A second reason i s that Peru and Bolivia, (among the principal destinations included in the international category in row B.1 of Table 3.2) have mounted their own Zonas Francas in areas bordering region I. This fact accounts for much of the decrease in international sales in row B.l - from US$1.218 billion in 1998 to only half of this (US$0.617 billion) in 2002. A further possible reason, one that came up in the various meetings in Region I, relates to the economic shock waves emanating from the 1998 Asian currency collapse. 4.33 Prior to drawing implications from the operations of ZOFRI, it i s appropriate to focus on the data relating to the industrial free-trade zone that operates in both Iquique and Arica. The relevant data here are the numbers of industrial enterprises in Arica and Iquique (rows A.l and A.2 of Table 3.2). For the twenty years following the creation of these industrial free-trade zones, the activity was roughly evenly split between Iquique and Arica in terms of the number of industrial enterprises, with Iquique generally in the lead. However, with the passing of Ley Arica in 1995 with its special provisions for industrial investment in Arica and the even more generous reworking of Ley Arica in 2003, the number of industrial enterprises established in Arica responded dramatically - from 33 in 1995 to 51 in 1996, and then from 52 in 2000 to 86 in 2001. Without commenting on the appropriateness o f the provisions of Ley Arica, it appears that this incentive has at least contributed to the creation of substantial number of new industrial enterprises in Arica. On the field trip to Region I, the team was informed that several more large multinationals were inthe process of establishing a presence in Arica. Moreover, as the ZOFRI analysis notes, the increase of new industrial enterprises following upon the revised Ley Arica in 2001 actually coincided with a downturn 27 While the analysis in the paragraphalso appearsin ZOFRI (2003,V.32), the same points were repeatedlymade by various individuals and associationswe met with on the field trip to Region I. 32 inoverall Chilean GNP growth, yet further evidence of effectiveness working intandem with the regulatory provisions of the Zona Fr~nca.*~ 4.34 Tables 4.2, 4.3 and 3.2, as they apply to Region I,are clearly reinforcing. The increase in the numbers and sales commercial and industrial enterprises in Region Iover the last quarter century are some of the major factors in the Region's population increasing by roughly 150percent over the same period. Indeed, this relationship between the Zona Franca and population growth has led to significant strains within Region Iitself. Inthe mid-1970's Iquique was very much smaller than Arica. Even as late as 1992 Arica's population was 161,333 compared with 151,677 for Iquique. B y the time of the 2002 census, Iquique had easily outdistanced Arica - 216,419 vs. 185,268. Finally, this i s consistent with the story in the Panel A data of Table 3.3, namely that Iquique appears to be particularly favored in terms of fiscal benefits (Le., costs to the Treasury). B y way of summary, then the Table 3.2 data (alone and in tandem with Tables 4.2 and 4.3) paint a very positive picture, perhaps dramatically so, of the impact of the free trade zone on Region I.It i s fair game to note, however, that the best days of the commercial Zona Franca are in the past, for reasons elaborated earlier. Likewise, it i s also appropriate to point out that Region Ihas benefited substantially from its geographical location. Indeed, far from being "extreme" in terms of geography, the port cities of Iquique and Arica now find themselves as important export gateways to the Pacific Rim (and especially to China which i s now Chile's third most important export destination, after the U S and Japan), and as expodimport gateways for central South America and the rest of Chile. In turn, this begs the question of whether Region Iwouldhavedonefairlywellevenintheabsenceofanypreferentialpolicies.Itmaywellbe the case that, looking forward, Region Ican lever off its emerging role as a Pacific Rim gateway. In summary, even though there i s no statistical evidence, without the preferential ZE policies, Region Iwould not currently be in a position to take advantage of this emerging gateway opportunity. In relation, although venturing much further a field, it could be speculated that the positive experience under ZOFRI may have provided one of the needed catalysts for Chile to have donned the mantle as Latin American's leading advocate of free and freer trade. 4.35 Ideally, it would have been desirable to have comparable data relating to the other free-trade zones. Unfortunately, this was not to be the case. Hence, the assessment of the role of ZE policies inRegions XI and XI1will have to proceed along more qualitative lines. Socio-Economic Indicators 4.36 From Table 2.1, the ZE regions fare exceedingly well in terms of a range of social and economic indicators-housing, education, poverty, infant mortality, incomes and GDP. The purpose of this section i s to provide a temporal perspective to most of these indicators. 28 Besides the instruments, other factors such as oil in Magallanes and mining in TarapacB, have contributed to development in these Zones. 33 I Tarapac6 175,208 428,594 2.5 I1 Antofagasta 251,976 410,724 2.0 XI Aystn 50,300 91,492 1.8 IV Coquimbo 338,646 603,210 1.8 XI1 Magallanes 89,443 150,826 1.7 I11 Atacama 153,888 254,336 1.7 VI O'Higgins 487.233 780,627 1.6 V Valparaiso 966,419 1,539,852 1.6 VI11 Bio-Bio 1,253,865 1,861,562 1.5 VI1 Maule 617,477 908,097 1.5 IX L aAraucania 602,010 869,535 1.4 X LosLagos 744,528 1,073,135 1.4 Metro Region 3,153,775 4,318,097 1.9 Chile 8,884,768 15,116,435 1.7 Source: NE,Census 1970 and 2002. Region 1990 1998 I Tarauac6 391.1 626.8 I1 Antofagasta 683.1 1294.2 I11 Atacama 308.5 651.2 IV Coquimbo 216.5 316.6 V Valparaiso 280.1 368.0 VI O'Higgins 295.3 396.1 VI1 Maule 195.1 301.2 VI11Bio-Bio 242.3 298.5 IX LaAraucania 126.3 188.1 X LosLagos 172.8 274.1 XI AysBn 247.8 377.7 XI1 Magallanes ME 824.7 869.7 338.4 540.32 Chile 330.1 550.1 4.37 Accordingly, Tables 4.4 and 4.5 present 1990 and 1998 data per capita GDP, for poverty, infant mortality and education dropout rates respectively. As already noted in Chapter 11, Chile has made enviable progress in reducing poverty-from 38.6 percent of the population in 1990 to 21.7 percent in 1998 (from the first two data columns of Table 4.5, where the poverty rate i s defined in the notes beneath Table 2.1). While all three ZE regions have poverty rates below the national average in both 1990 and 1998, the performances of Regions XI and XI1 are quite remarkable. AysCn has cut its poverty rate by over 50 percent (31.0 percent to 14.8 percent), while Magallanes has nearly cut poverty to a third of its 1990 34 value (from 30.1 percent to 11.8 percent). What i s equally remarkable about the poverty data i s that five regions have poverty rates in the 20-30 percent rates and Bio Bio and Araucania have rates in the range of one-third of the population. This i s dramatic evidence of the inequalities across Chile's regions and raises societal concerns with respect to the generosity of the allocations to the ZE regions documented in Panel B o f table 3.3-- concerns that will be addressed later inthe report. Table 4.5 Social Economic Indicators 1990 -1998 ( percent) I Region Poverty Rate Infant Mortality Dropout Rates Dropout Rates (per 100 inhabl) P r i i a r rSchool 1990 1998 1990 1998 1990 1998 ITarapacti 28.3 16.1 12.5 8.9 1.9 5.3 I1 Antofagasta 34.1 13.2 15.7 13.0 1.5 1.7 8.5 3.8 I11 Atacama 34.2 28.5 20.2 14.9 1.5 1.1 8.2 4.6 IV Coquimbo 45.5 25.1 16.3 11.3 1.7 1.o 6.9 5.7 V Valparaiso 43.0 18.8 15.4 10.9 2.4 1.7 6.9 4.5 VI O'Higgins 41.0 22.7 14.6 10.6 1.8 0.9 7.2 3.4 VI1 Maule 42.7 29.3 16.7 10.1 2.4 1.1 7.5 4.1 VI11 Bio-Bio 48.2 32.3 18.7 13.4 2.4 1.o 8.4 3.9 IX La Araucania 45.1 34.3 26.6 12.4 2.9 1.2 10.0 4.8 X LosLagos 40.1 29.4 21.5 11.5 2.4 1.4 8.5 5.3 XI AysCn 31.0 14.8 21.6 12.1 2.7 1.o 10.2 5.7 XI1Magallanes 30.0 11.8 16.1 9.2 0.7 0.6 4.2 2.9 MR 32.9 15.4 14.7 9.7 2.4 4.1 Chile 38.6 21.7 16.8 10.8 2.3 4.3 Source: CASEN 1998. 4.38 Infant mortality rates appear in columns 3 and 4. Tarapaca tops the list in both years with Magallanes in second place in 1998, rising from sixth in 1990. AysCn scores a poor ninth in 1998, albeit up from twelfth in 1990. 4.39 Region XI1had primary school dropout rates in 1990 that were less than half of the second-place finisher (Regions I1and I11tied with 1.5 vs. 0.7 for Magallanes). Region XI1 kept the lead in 1998 but the rest of the regions have substantially narrowed the gap. TarapacB trails all regions in 1998, worsening its dropout rate from 1990-1998 while most other regions improved theirs. Region XI1 repeats its stellar performance for high-school dropout rates as well. AysCn' s performance for both primary school and high school improved substantially over 1990-1998 and for 1990 i s scored better than the national average. 4.40 Table 4.4 present per capita GDP for 1990 and 1998 (annual). In 1990 Region XI1 prevails once again but fell to second place behind Region I1in 1998. Region Ialso dropped one place over the period, from third in 1990 to fourth position behind Region I1in 1998. This drop inranking has little to do with the performances of Regions Iand XII. Rather the story i s about the spectacular GDP growth of Regions I1and 111, largely driven by the exports of the mineral sectors inthese regions. Since much of the resource-based GDP will not flow through to residents of these regions, it should not come as a surprise that in terms of household income (column 6 of Table 2.1)' Region XI1comes off better than regions I1and 111.Finally, 35 AysCn actually enhances its GDP ranking-from eighth to seventh-but it remains well below the Chilean average. 4.41 Table 4.6 presents the 1990 and 1998 regional allocations of transfers for social expenditures and public investment. Note that while these are the same categories that appear inPanelB of Table 3.3, the Table 4.6 data relate to the entire regional transfer whereas those inTable 3.3 dealt only with the excess or preferential amounts allocated to the ZE regions. In 1990, Regions XI, XI1 and Iare first, second and fourth respectively in terms of per capita social transfers. In 1998 they are the top three. And AysCn and Magallanes are well above the other regions. This i s even more true for the public investment transfers-AysCn gets 5.7 times the national average in 1998 and Region XI1 receives over four times as much, both much higher than was the case for 1990. This suggests that the substantial preferential treatment for Regions XI and XI1 so evident in Table 3.3 essentially represents a 1990s build up of these preferences. Phrased differently, already well-off Magallanes (in terms of social indicators as reflected in the 1990 data in Table 4.5) in further privileged in terms of excess transfer allocations. Table4.6 Public SocialandInvestmentExpenditures(US $ per capita) Region Social Public Expenditures Public Investment ITarapach 146.2 334.2 54.4 131.2 I1 Antofagasta 146.9 281.9 39.1 110.2 I11 Atacama 142.2 272.7 54.6 145.0 IV Coquimbo 127.4 297.9 33.7 157.2 V Valparaiso 148.5 331.7 47.1 54.6 VI O'Higgins 107.5 221.7 41.3 92.9 VI1 Maule 112.6 237.8 33.6 123.4 VI11 Bio-Bio 121.2 275.1 26.7 74.7 IX LaAraucania 122.1 268.7 33.3 117.2 X LosLagos 119.3 272.1 37.3 71.3 XI AysBn 188.9 504.1 38.6 440.3 XI1Magallanes 179.3 410.7 65.4 328.8 MR 128.9 242.7 26.7 41.8 Chile 128.6 268.0 33.71 77.8 4.42 Finally, Table 4.7 focuses on some aspects of the temporal behaviour of regional labor markets. Region Iwith a labor-force growth rate o f 31 percent (last column o f the table) i s second only to Region 111. Region XII's growth rate i s slightly below the national average while that of AysCn i s slightly above. This higher labor force and employment growth in Region Ii s corroborated by earlier evidence (Table 3.4) which indicates a rising cost of the wage subsidy over the 1990s, especially in Iquique where there has been a five-fold growth, whereas the 1998-2001 data for Region XI1 i s essentially flat. All three regions have unemployment rates below the Chilean average in 1998. 36 Table 4.7 Unemployment 1990-1998 DnArr" Labor Force Employed Unemployment Labor Force I.r~jl",, (000) (000) ( percent rate) Increase 1990 1998 1990 1998 1990 1998 1998/ 1990 ITarapach 120.6 158.4 111.2 144.2 7.8 9.0 1.31 I1 Antofagasta 136.9 165.5 125.2 153.1 8.5 7.4 1.21 I11 Atacama 78.1 110.4 6.9 101.5 11.1 8 1.41 IV Coquimbo 171.0 207 153 187.7 10.6 9.3 1.21 V Valparaiso 489.8 577.5 44.5.7 504.4 9.0 12.6 1.18 VI O'Higgins 237.9 281.5 223 261.1 6.2 7.3 1.18 VI1 Maule 315.1 336.2 288.5 306.8 8.4 8.8 1.07 VI11 Bio-Bio 603.1 672.3 559.7 606 7.2 9.9 1.11 IX La Araucania 259.0 289.3 248.3 264.1 4.1 8.7 1.12 X LosLagos 309.8 382 301 359.2 2.8 0.6 1.23 XI AysBn 30.7 38.3 29.8 3.6 0.2 4.4 1.25 XI1Magallanes 56.3 66.4 54.1 61.5 4.0 7.4 1.18 MR 2,016.1 2,542.2 1,841.2 2,268.8 8.7 10.8 1.26 Chile I 4,824.3 5,826.9 4,450 5,255.1 7.8 9.8 1.21 Source: INE. 4.43 In summary, the ZE regions are, in general, doing very well. But how much of this has been due to the ZE policies?To this important issue we now turn. HowEFFECTIVE THEZEPOLICIESBEEN? HAVE 4.44 The role of Chapter 5 i s to evaluate the various instruments that comprise the constellation of ZE policies and to recast them in light also of the manner in which the ZEs themselves have performed and especially in which the global economy has and i s evolving. The purpose of this section i s at the same time more general and more subjective. This i s so because in attempting to assess the role of ZE policies on the often stellar performance of Regions I, XI, and XI1the remainder of this chapter assesses the results of policies as a whole and not instrument by instrument. The current social and economic indicators for the ZE are the result of many internal and external factors, including the ZE and other government policies. Therefore, it i s difficult to rigorously isolate the effects of the ZE policies. Nonetheless, the following overview generalization appears supportable on the basis of the above evidence: The set of fiscal incentives for private enterprises (as presented in Panel A of Table 3.3) and especially the operations of the Zona Franca contributed to the successful economic lift-off experienced by Region I, whereas the set of preferential regional allocations of public social and investment transferdexpenditures did equally contribute to the emergence of the superb social infrastructure and social performance of Regions XI and XI1 and especially the latter.29Note that this i s not to take sides on whether the social or the economic i s preferable because the remainder of the analysis i s conducted in the context of the information era where social policy (human capital formation) and traditional economic 29 There i s clear evidence of close correlation, but not enoughsolid information to affirm there i s direct causality. 37 policy are both essential ingredients for achieving international competitiveness. Elaborating on this overview leads rather naturally into dealing with the north and south "extreme" regions separately. This analysis begins with the north. RegionI 4.45 The evidence appears overwhelming, at least at first look, that the (Table 111.7, Panel A) policies anchored around the commercial and industrial free-trade zones spearheaded the economic blossoming of Region I.This i s the story (admittedly a correlation and not necessarily a causation story) that i s told in Tables 4.2, 4.3 and 3.2. The causal component takes on more credibility when the focus i s internal to Region Iand on the likely role of the commercial Zona Franca in Iquique as the essential catalyst in transforming a small desert town into an economic dynamo and the largest city inRegion I. 4.46 Having said this there are at least three caveats that merit highlight. The first one i s the old chestnut: Could this have been accomplished more efficiently, Le., at a lesser draw on the Treasury? With hindsight the answer to this question i s always and emphatically "yes!" Indeed, and as already noted, Chapter 5 will propose, instrument-by-instrument, superior (less costly for any given benefit) approaches to the current complement of ZE policies that are geared to the new global environment. At another level, however, this i s not a very interesting question because the practice of economic development i s strewn with good intentions and failed policies. Success i s rare, and while it i s always important and valuable to submit all policies to efficiency audits, it i s also important to not to downplay success, even if it occurs within the framework of a set of policy incentives and incentives that probably at best can be described as a patchwork quilt. However, the two remaining, and related, caveats seem more important interms of future policy toward this region. 4.47 The first i s that whatever may have been true of the degree of isolation of Region I at the inception o f the ZE policies (1975), Region Ii s anything but "extreme" in any geo- economic sense in 2003. Indeed, it i s situated at the crossroads of a series of lucrative "gateways"-linking parts of Peru, Bolivia and western Mercosur to the Pacific Rim and vice versa; engaging in North American and Japanese commerce; and more recently taking advantage of the economic resurgence of China (already Chile's third largest trading partner) and positioning itself as a Chinese gateway to Mercosur, Central America and even NAFTA. Obviously, all of this has emerged entirely independently of the ZE policies. More importantly, Region Imay well now have a future equally independent of ZE policies, and in Chapter 5 we shall detail what this future might entail. Even were all of this to come to fruition, it could not be interpreted as testament to the effect that the ZE policies were, in the final analysis, irrelevant. This i s so because the economic jump-starting was partly provided by the ZE policies. The related point, alluded to earlier, is that the remarkable success of the Region IZona Franca may well have provided a valuable "demonstration effect" that donning the mantle o f South America's premier free trader was the way of the future for all Chileans. 4.48 This leads to the final caveat. With or without its Pacific gateway future, the commercial free-trade zone i s a spent force. In the middle of 1975, with tariffs at 30 percent this was a creative and effective policy. But with tariffs now of the order of 5-6 percent and 38 heading to zero in a few years, there i s no rationale for anchoring a set of policies around a free-trade zone. Perhaps this need to be qualified somewhat: the tariff-free aspect of the free- trade zone has become underminedby the dramatic reduction in tariffs. As will be elaborated later, there are other aspects of the free-trade zone such as the flexible regulatory framework that will loom important inany Pacific gateway strategy, for example. 4.49 The analysis thus far i s also important for what it did not focus on, namely the panel B (Table 3.3) instruments. An argument can be made that as the economic future of Region I became less in doubt, there was ample scope to pare back the generosity of the Region I preferences built into the national allocation system for social and public investment transfers to regions. It i s hoped that they have not evolved into "entitlements," since the regional data in Table 3.3 and the various tables in this chapter paint a portrait of quite dramatic regional disparities. While these preferential transfers played a role inthe economic success of Region I, arenowneededmuchmoreinotherregions. they Shift-Share Analysis 4.50 As a bridge between the above discussion and the following one relating to the southern ZE regions, we report briefly on the results o f a shift-share analysis for all three regions over the 1986-2001 period for both output and employment growth. . Shift-share analysis i s a method for allocating a given growth rate into two component parts-a "share" part and a "shift" part. Focusing only on the employment growth results, shift -share analysis calculates how each region would have performed over the given period had its initial occupational/industrial employment classification remained in place throughout and grew at the all-Chilean average for these employment categories. This produces the "structural" growth rate for each region-what would have emerged had its initial employment structure grown and national-average rates. The difference between a region's actual growth rate and this structural rate (where this difference can be either positive or negative) is the "regional" growth rate, or the result of the shift in the region's shares or structure of employment. The results for the employment growth changes appear in Table 4.8. the actual employment growth rates for the regions are 53 percent, 47 percent and 22 percent for Regions I, XI, and XI1respectively, with Chile recording a 44 percent growth rate (see column 1). Were each region to have maintained its employment structure and were this structure to have experienced national growth rates for the various employment categories, the results would have been those of column 2 of Table 4.8, namely that Regions Iand XI1 would have both grown by 48 percent, whereas AysCn would have recordedemployment growth of 35 percent. Column 3, labelled "regional growth," presents the residual (actual growth less structural growth). Relative to Chile, Regions Iand XI1can be seen to have an advantageous structure because from column 2 both would have grown faster than the Chilean rate of 44 percent, Le., their initial employment was located in faster growing industries/occupation. For Region I, this 48 percent structural growth rate is less than the actual growth rate of 53 percent so the Region 1's regional growth rate i s plus 5 percent. That is, something other than the region's initial employment structure i s influencing the regional growth. And included in the "other" category could be the effect of the ZE policies. The opposite i s true for Magallanes. Its structural growth i s much more than its actual growth, which implies that it i s receiving a negative regional shock of minus 26 percent. There are several ways to interpret this finding. 39 For example, one version would say that Region XII i s disadvantaged that it would probably have lost employment had it not received the benefits from ZE policies. Aystn's results are different still. From the fact that its structural employment growth was less than its actual growth (35 percent vs 47 percent) indicates that its labor force was employed in slow growing industries. The positive regional effect for Aystn (11 percent, from column3) suggests that some external factors have been at play interms of spurringthe region's employment growth. Again this could be ZE policy. Table 4.8 Shift Share Analysis of Employment and Output Changes 1986-2001 Effective Structural Regional Growth Growth Growth Employment (1986-2001) Chile 44 % 44 % Tarapac6 53 % 48 % +5 % Aystn 47 % 35 % +11% Magallanes 22 % 48 % -26 % Output (1986-1997) Chile 113 % 113 % Tarapach 126 % 114 % +13 % Aystn 107 % 97 % +10 % Magallanes 33 % 101% -68 % Source: INE. RegionsXI and XI1 4.51 Recalling that the role of this section i s to assess whether the combination of ZE policies has served Regions XI and XI1 well, the affirmative answer might be crafted along the following lines. At the inception of the ZE policies, Regions XI and XI1 qualified as extreme regions in a variety of ways-distance from the centre, geographically, weather-wise, cost-of-living wise, transportation-wise, among numerous other dimensions. Nearly thirty years later, these regions remain extreme in all these same ways, save perhaps for the advent of the Internet. In light of these circumstances, that these two regions maintained their share of Chilean population (and AysCn actually increased its share) i s really quite impressive. To see that this i s indeed remarkable, one needs to take a closer look at the regional growth rates inTable 4.4. The six slowest-growing regions (inorder of declining growth rates) are: VI, V, VIII, VII, Mand X. Note that this i s a near-perfect ranking from Region V to Region X. In other words, the further south a region i s from the centre, the slower i s its rate of population growth. But not only are Regions XI and XI1further south still, they are surely more extreme, in the above-enumerated ways. Hence one can be quite confident that, left to their own devices, Regions XI and XI1 would have wound up in twelfth and thirteenth place respectively in the Table 4.4 rankings. That Aystn i s in fourth place and Magallanes i s in sixth must surely say something about the impact of ZE policies. 4.52 Region XI1 scores above average in terms of each and every social or socio- economic indicator included inTable 2.1 (i.e., columns 5 through 10).And to this one can add 40 primary and secondary school drop-out rates (Table 4.5) as well as unemployment rates.30 In a sense, this i s partly the creation of ZE policies and in particular the very generous public social and investment transferdprograms reflectedinthe panel B data inTable 3.3. 4.53 By way of concluding comments, four observations appear appropriate. The first is that a not-insignificant part of the large transfers flowing to the southern ZE regions can be rationalized on cost-of-living differences and cost-of-construction differences. Second, it i s generally the case that developed nations with "extreme" regions spend much more inthe way of transfers on them, relative to what the regular regions receive. Canada's ten provincial governments spend roughly US$5,000 per capita and the poorer provinces have their revenues brought up to this level via equalization payments.31 However, the northern territories (Canada's extreme regions) spend in the order of US$15,000 per capita and most of this comes in the form of transfers from the centre. Australia and its Northern Territory i s another case inpoint. Closer to home --and at a more comparable level of economic development, the Argentine federation transferred monies to its Patagdnicas Regions (T. del Fuego, Santa Cruz, Chubut, Rio Negro and Neuquen) US$9,445 per capita in 2001 approximately. In particular Tierra del Fuego accounts for several times the average of what it transfers to other provinces, US$2,970 approximately. In the case of the Argentine federation, the transfer to the Patagdnicas includes i)a special privilege to the Patagbnicas, consisting of the regalias they receive for hydrocarbons extracted intheir provinces, which they get directly from the oil companies (but the rate and base are set by federal law, not provincial law), and ii)non- automatic transfers such as gas subsidy. 32 4.54 A glance at a high-end benchmark, the EU assistance to four lagging countries- Ireland, Greece, Spain, and Portugal-illustrates the point that greater scope, volume, and concentrated effort may be needed to achieve this larger goal of expansion. After adjusting for relative levels of wealth, the level of effort in Chilean assistance i s a fraction of the effort, relative to GDP per capita, put into development of lagging regions inEurope. See Table 4.9. Table 4.9: Comparisonof EUand ChileanAssistance to LaggingRegions" Indicator EUAssistanceto Four Chile Ratio Countries GDP of the `centre' 10.5 T 70.1 B Population of the whole (millions) 379 15.1 25 Per cap income (US$) 27,000 4,500 6 Pop. Inlagging regions 83 m (in 4 countries) 100,000 inAysCn Source: World Bank estimates. 30 It i s important, however, to bear in mind the other influential factor to economic successRegion XII: oil 31 Average Transfers to all Regions were CAN$4,753 per capita in 2003, and CAN$28,448 to the Nunavut Province. 32 World Bank estimates based on data provided by the Government of Argentina, mainly Direccidn Nacional de Coordinacidn Fiscal con las Provincias and Secretaria de Programacidn Econdmica y Regional. For Santa Cruz and NeuquCn no provincial information was available, thus we used estimates. 41 4.55 AysCn was closely reviewed and it i s doubtful whether it i s equipped to handle the complex tasks that require sophisticated tradeoffs in efficiency and equity. Evidence was found that the comunas in AysCn were engaged in the targeting of poverty assistance programs, a modality that Chile has pioneered and developed to an effective degree. Chile has proven that comunas can help to guide and advise on direction and effectiveness of national programs. But nothing can substitute for the central governments role (in practice and theory) to deal with horizontal equity across regions. 4.56 OECD and the EUboth have long experience with equalization, in analysis and, in the case of the EU, programs of assistance. OECD's recently reorganized program on Territories has produced numerous consultations, studies and books, too numerous to cover here. Work on Mexico and Ireland would be two specific examples likely to be suggestive of ideas and benchmark efforts. 4.57 The EU programs in territorial equalization have run since the mid 1980s. Disparities are measured in several ways. The four poorest states have GDPs only 80 percent of the average for the EU. Also, the EU has identified 250 distinct regions. The 10 most dynamic regions have a GDP three times the least developed. O f the many programs of assistance, EU Objective Ii s most relevant. In it, the EU ". ..shall aim at reducing disparities between the levels of development of the various regions and the backwardness of the least favored regions or islands, including rural areas". To achieve this, the EU finances various programs, under principles of unity and cohesion among members. 4.58 According to the EU, ... Objective 1 region, the Funds contributed about 1/2 " percent per year to growth between 1989 and 1999. The cumulative effect added about 10 percent to GDP in Greece, Ireland and Portugal and over 4 percent in Spain. Inother words, a third or more of the economic convergence of these countries would not have happened without the Structural Funds. More specifically, it i s estimated that in 1989-99 in all the assisted regions of the Union some 2.2 million jobs were maintained or created thanks to the Structural Funds" (EU"Inforegio" Reports) 4.59 The third observation should, in light of the above analysis, hardly be surprising: continuing with ZE policies i s in the context of 2003 much more important for the southern ZE regions than it is for the northern ZE. Region Ihas a chance to lever its current strengths into a Pacific gateway role that will allow growing out of its ZE-policy dependency. Regions XI and XI1 have no such prospects.33The final observation flows from the third. The analysis has in the process of assessing ZE costs and benefits revealed a quite disturbing degree o f inequality across Chile's regions. At the very least these inequalities merit first call on any new regional policy initiatives. 33 SeeAnnex B Section2 for moredetails on what RegionXI is doing. 42 CONCLUSION 4.60 This completes the assessment of the costs and benefits of ZE policies. The document now has some of the essential backdrop to inform the remainder of the analysis which will focus on the policy implications and proposals and, more generally, will focus on the rethinking and reworking of Chile's policy toward the Zonas Extremas. The report makes use of this concluding section, perhaps better termed a bridging section between the cost- benefit assessment and the policy implications, to frame some of the issues relating to the ZE policies and practices that will merit attention inthe ensuing analysis. 4.61 The first of these issues or concerns i s that because the ZE policies are more in the nature of a collection of instruments than an integration among instruments, and because the ZE likewise comprise a selection of regions, provinces, and comunas rather than a set of defining criteria, both instruments and the areas that come under the umbrella of the ZEs will be under pressure to expand. Thus the province of Tocopilla in Region I1becomes a recent addition to the ZEs. And interms of instruments, the introduction of Ley Arica in 1995 and its reworking in 2001 reflect the system's vulnerability to political and interest group pressure. 4.62 Relatedly, the fact that the geographical, demographic, economic and social characteristics of the north and south of Chile vary considerably, the existing complement of ZE policies do not appear to be adequate for targeting the specific needs and opportunities facing the separate ZE regions. 4.63 The experience has been that the legislation relating to the specific policies i s highly complex and difficult to understand for parliamentarian and pubic officials alike, let alone average citizens. That the report will constitute the first effort to quantify and consolidate the aggregate costs and benefits of ZE policies speaks directly to this issue. This lack of transparency and of public information generally will play onto the hands of those interests in the region adept at rent seeking and rent keeping. However, the complexity and dispersion of instruments i s such that even those in the benefiting regions are finding it difficult to adopt a horizontally integrative strategy (Le., harmonizing across all instruments), rather than focusing vertically and separately on the individual instruments. The team was told on the field trips that part of the challenge here i s to bring local expertise and civil society groups more formally into the design and delivery stages. 4.64 The forgoing analysis has not rendered a comprehensive assessment of individual instruments in terms of their effectiveness or how they might be re-deployed. Rather, the assessment has been inthe form of the overall role of ZE policies in meeting ZE objectives. It i s quite consistent to give passing marks to the system and at the same time to find that virtually every instrument can be made more effective. 4.65 Zonas Francas were state-of-the-art instruments in the high-tariff 1970s, and their success came about in part because they were a forerunner of the way the world was evolving so that they provided the country or region with a first-mover advantage, as it were. The world of 2003 has moved beyond Zonas Francas. We are in the throes of the information era and a human-capital revolution. Chile's economic geography has altered dramatically with the emergence of China as a powerful Pacific trading nation, with Mercosur offering new 43 opportunities eastward for many of the Chilean regions, and with NAFTA and the proliferation of FTAs opening up Central and North America, all of which speak to the need to develop creative and presumably transformative and dynamic instruments and approaches to match these new opportunities. 4.66 For all of these regions the study need to rethink and rework the entire range of ZE policies and approaches with an eye to making them more efficient not only intheir own right but ensuring as well that they resonate collectively with the challenges and opportunities facing 21st century Chile. 4.67 Accordingly, the report approaches the policy implications and policy options aspects by focusing on three clusters of policy options that progressively embody more ambitious and forward-looking approaches. In Chapter 5, Section A, the report address the streamlining and refining of existing policy instruments with a view to increasing their effectiveness for a given amount of cost, or to reduce fiscal costs where the benefits of the instrument are considered to be negligible. Section B of Chapter 5 then begins with a second policy cluster directed toward implementing a targeted approach to developing the North and the South in a diflerentiated way by incorporating their respective, and significantly different, growth potentials into instrument design. This will serve to convert the static and defensive Zonas Extremas into a more aggressive, anti-poverty-focused and growth-oriented zonas estratbgicas policy. The remainder of Chapter 5 addresses a group of options that take Chile beyond Zonas Extremas to embrace the vision of a need for, and avenues toward, a more coherent and dynamic regional policy for the whole of Chile, not just for the currently designated ZE regions. This would require more fundamental reform of the present institutional setting for policy making and governance in the public sector with the aim of strengthening local public decision-making and accountability. It would also require a more comprehensive view of a human capital based, anti-poverty focused, and growth- and export- oriented regional policy inChile. 4.68 The study now turns to a reconsideration of fiscal subsidies and public policy measures as they relate to the ZEs. 44 CHAPTER 5. IMPROVINGTHESCOPEOFREGIONALIZEDPOLICIES. ALTERNATIVEAVENUESFORPOLICY REFORM INTRODUCTION: REMAINING POLICY QUESTIONS 5.1 Chapter 4 concluded with an assessment of possible impact of incentives for ZEs on population, economic activity and socio-economic indicators. Assuming differential development between ZEs and other regions of the country i s primarily due to ZE policies, there still remain two sets of policy options that should be further explored. First, it i s necessary to discuss how can current instruments be adjustedleliminated or improved (Section B of this Chapter); then, the report needs to explore, more broadly, how can policies altogether be improved, either in terms of renewed objectives or new instruments (Sections C and D of this Chapter). IMPROVING CURRENTINCENTIVEINSTRUMENTS 5.2 At least two factors justify further discussion of improvement of current incentive instruments for ZEs. Given the low density of population, notably in the South, the fiscal costs of the ZE policies are relatively small compared with the total of tax expenditures that the Ministry of Finance has recently estimated to be about 4.3 percent of GDP. Moreover, these costs, which this study has tried to quantify and consolidate for the first time, are highly dispersed as they associate with several instruments. The dispersion of costs by instruments produces non-transparency, which also contributes to protecting local interests. Tax exemptions appear to be difficult or expensive to control and appear to create room for tax evasion. While the direct fiscal costs could be bearable for a country like Chile, the efficiency costs of ZEs might be high, especially in a dynamic perspective. The regional policy instruments.now in place are likely to fail producing the structural change needed to sustain economic growth over the longer run. There i s the suspicion that this problem i s more prominent for the North than for the South. 5.3 This Section addresses the challenge of instrument improvement by responding to the following questions: Do policy instruments remain as effective today as when they were first introduced? Alternatively, did those instruments already reach their peak and are currently less effective or are expected to decline in the near future? How to make current policy instruments more effective or how to enhance their cost/effectiveness? A reconsiderationof fiscal subsidiesandpublic policy measures 5.4 As a general remark, streamlining and refining the various instruments used to foster and support the ZE in Chile can reap major gains. This section will develop and explain some of the options in more detail. However irrespective of what measures might be deemed to be appropriate b y the Chilean authorities and what policies might be pursued, there i s an urgent need for regular reporting and auditing, and for comprehensive analysis of the effects of the various instruments on a recurrent basis. It i s not sufficient to commission a one-off study 45 once in a while. After the stocktaking of the present study there i s a chance for monitoring regional policies on an ongoing basis, which i s needed to guide policies over time by continuously evaluating their results and by routinely triggering policy reactions before developments have taken an irreversible pace inthe wrong direction. Free tradezones 5.5 The free trade zones existing in Chile have similar, but not necessarily homogeneous, legislation. Initially introduced in 1975, the legislation (DFLNo. 341) intended to favor the municipalities of Iquique in the 1st Region, and Punta Arenas inthe 12th Region. Using a privilege given to himby law, the President has extended the limits of the free trade zones beyond their original delineation creating a so-called "extended free trading zone". And a similar regime was introduced for Arica by Law (no.19.669) with a clearer focus on industrial development. A new industrial free trade zone was created as recent as 2002 in Tocopilla. 5.6 The further development of free trade zones and similar provisions found in other legislation - such as the Ley Navarino (no. 18.392)34 and the Ley Tierra del Fuego (no. 19.149) - will hinge on a clear and coordinated regional strategy for these zones of the government. It i s obvious that the authorities will remain "locked in" as to their free-trade- zone policies because the resistance to policy change by local rent keepers will remain strong -andis nourished bypointingto neighboring stateswith asimilar economicallyinefficient policy-as long as the government i s unable to present a convincing policy alternative. So there i s need for a clear concept for further evolving the now free trade zones. Some more specific alternatives for developing the South and the North are presented below; but the available options may even lead beyond the present approach to favoring particular regions. This will also be discussed further below. 5.7 As mentionedearlier, the free trade zones had a strong regional impact as long as the country remained comparably closed and protective economically. With the reduction of customs duties through the competitive opening-up of national economies and the stronger economic integration into the region and the world economy, some of the benefits of free trade zones will fade away automatically. The sheer purpose of a free trading zone changes in a world that will increasingly become service- and export oriented. However other benefits will remain and ought to be examined against changing economic conditions and policy objectives. 5.8 As was explained previously - and will become even clearer after having designed some alternative concepts for economically developing the extreme zones-, the fostering of a human-capital driven service economy will require new instruments of regional policy, definitely others than the traditional ones focusing on industry and commerce. The further 34 Ley Navarino is not well designed. It i s highly inefficient and distorting. As the sales subsidy amounts to 20 percent of the sales price (excluding VAT due to the Free-trade zone) and the value added only needs to exceed 25 percent of the output, the incentive can in fact finance all of the labor cost incurred. Additionally, it i s easy to fulfil the requirement if the supplier of the good i s the same as the recipient of the subsidy. Through accounting measuresthe company can offset all of the production cost in the ZE, thus increasing their profit. On the other hand the subsidy is crowding employment in other 46 evolution and improvement of the various instruments for free trade zones must therefore be made against the background of export-oriented economic developments that are determined by highvalue-adding qualified services. 5.9 The main benefits of a free trade zone can be categorized as follows: (i) exemption from customs duties; (ii) special arrangements and benefits regarding VAT; (iii) exemption of enterprise income from income tax (business tax); (iv) and exoneration from the local real estate tax. The options for further developing each of these instruments might be sketched as follows: Exemptionfrom customs duties 5.10 This instrument is about to lose its bite. As customs duties have come down and might eventually disappear with integrating national economies of the region, the monetary benefits of these instruments become negligible. The now favored agents in the territories could eventually abandon them without provoking too much resistance. 5.11 However one ought to stress an important point relating to customs administration that has more general implications for free trade zones and for regional development in Chile: Exempting foreign trade relations from duties represents a "light" regulatory framework that i s highly attractive for traders.35 Excessive regulations might be extremely onerous for business and trade, and they represent costs that could easily outweigh by far all other fiscal benefits given to business inthe free trade zone. 5.12 So regulatory policies are essential for regional development, and they can produce economic benefits at little or no fiscal costs. It i s therefore essential that the light regulatory framework of free trade zones ought to be preserved even beyond the administration of customs duties, and be eventually expanded to the whole of the Chilean economy. Benefits under VAT 5.13 The benefits accorded to eligible economic actors of free trade zones - that are more fully evaluated above-accrue basically to: (i) exporters to other countries; (ii) doing firms business with the rest of Chile; (iii) local final consumers; and (iv) final consumers from abroad (tax-free induced "tourism"). 5.14 Exporters to other countries do not produce fiscal costs, as their trade i s zero-rated anyway under a VAT using the destination principle. The benefits of exporting firms consist only of a liquidity effect and the virtues of a "light" regulatory framework. 5.15 Business firms trading with the rest of Chile are in a similar situation as exporters. As they can "export" into the rest of the country VAT free, one might suspect a fiscal cost and a corresponding benefit to these traders. But to the extend they are trading with other firms, 35 Broadly speaking, "light regulatory framework" refers to simplified procedures, absence of (or reduced) transaction fees, standardized and transparent rules, lack of discretionary action, all of which contribute to reduce time (opportunity cost) and cash transaction costs. As such, a light regulatory framework i s today an essential ingredient of a positive, competitive business environment. 47 VAT foregone at this stage will be recouped at later stages of processing and distribution. So again their main benefits consist of a liquidity effect and the virtues of a "light" regulatory framework. 5.16 It is obvious that the main benefit of VAT exemption rests with local final consumers and consumer tourists. Favoring local consumers does not represent an export- driven growth strategy however. Favoring Consumer tourists i s highly dubious under welfare aspects - because it simply diverts trade at welfare (transportation) costs -, although it might offer some extra benefit to the favoring region as it generates extra demand for goods and local services b y these consumer tourists. This could eventually lead to countervailing actions by neighboring countries that aim at protecting their own resources and service industry. In any case exempting localized final consumption will not escort a regional economy into a competitive high value generating modern economy. 5.17 The distortion of these incentives (Customs Duties and VAT Exemption) i s relatively mild. As the goods are subject to the duty once they leave the free trade zone, only goods consumed in the free trade zone are free of charge. The effect of the incentive i s to attract industries to produce and process goods to be re-exported, to take advantage of comparatively lower wages than in the importing countries. However, the tax exemption of private consumption creates negative externalities, as "Customs and VAT -Tourism" will draw business from other areas. 5.18 As a consequence, one option appears to be phasingout the benefits accorded to free trade zones under the VAT. This would reduce the fiscal costs to the extent that local consumption would lose its privileges; it will be more or less revenue-neutral as far as exporting and inter-enterprise i s concerned. Although there might be some gains to the extent that the present arrangements, heavy in costs of surveillance to control abuse, can be dismantled and integratedinto the normal process of VAT administration. 5.19 However there exists an alternative that could become the option for government to cope with potential resistance of such a radical measure: the scheme could be maintained as a so-called drawback zone for firms only ("enterprise zones"), and it would be regionally well delineated and attached to specific "gateway" activities of exporters and imp0rte1-s.~~These firms would continue to benefit from the light regulatory environment and from simplified tax administration of the scheme with little fiscal costs for the nation. 5.20 Personalized transfers targeted toward the poor could eventually compensate the loss of privileges by local consumers. 36 See Annex D for more details on special zone initiatives active in other countries, such as Enterprise Zones and/or Export Processing Zones. 48 Exemptionfrom the business income tax 5.21 Exemptions from the business income tax encourage tax "arbitrage" and are highly i n e f f i ~ i e n tThey are also extremely difficult to monitor or entail high compliance costs both . ~ ~ for the taxpayer and the tax administration. Such costs can easily outweigh the presumed "benefits" o f the instrument, which could even turn negative in this case. This i s because measures against "tax arbitrage" are costly and imply heavy costs of reporting, administrative control, and interference in market activities. 5.22 Tax arbitrage will occur because an income-tax concept i s typically based on a national (even world-wide) income concept, not on the region. And it considers net income, not gross income or yield (which could eventually be attributed to a region). If (net) income by region is tax exempt, there is a considerable advantage to channel (gross) revenue flows through the benefiting region, and to shift costing elements out of the region to reduce the (taxable net) income of the company elsewhere in the country. This i s highly inefficient for the company itself, and it produces fiscal costs that go well beyond the direct costs measurable inthe free trade zone. 5.23 This incentive has a potential for very strong distortions. Considering the indefinite timeframe of the subsidy creates and incentive to relocate the company headquarters to the free trade zone, without generating morejobs or production. Such a move i s a direct negative externality towards the other regions. Thus any such incentive could be limited to newly established companies, and limited in time. Ideally, the cost of relocating a company and the tax incentive would neutralize in a way, such that existing firms would have no incentive to relocate. 5.24 It is therefore recommended to abolish this type of privilege. Where there appears to be need to foster some regional economic activity at all, this should preferably set off from value added, not business income. A substantial part of value added consists of wages and salaries, which are linked to human capital formation. So the key fiscal instruments of a modern knowledge-based economy of the 21Stcentury must be geared toward developing human capital and creating value added, in addition to investing in physical capital and infrastructure. 37 As used inthis context, "tax arbitrage" refers to tax loopholes created by provisions that leave up to the discretion of the taxpayer to artificially (and inefficiently) reallocate the factors that constitute the tax base in order to reduce the tax due. Trading that takes advantage of a difference intax rates or tax systems as the basis for profit. Examples: 1) borrowing to invest intax-exempt municipal bonds. Also, it may loosely be defined as a phenomenon, in which an inconsistency inthe substantive law of two or morejurisdictions yields a tax benefit that would not be available if the laws of the relevantjurisdictions were completely harmonized. 2) taxpayers engagedin tax arbitrage may be able to duplicate valuable tax attributes, such as deductions or losses. I t has been argued that depending on circumstances, government's strategic interests may be best served by curtailing, ignoring, or possibly even creating arbitrage opportunities. 49 Exonerationfrom the local real estate tax 5.25 The real estate (or property) tax i s a typical local tax, so exoneration from this tax i s an extremely effective device to foster regional development. In fact, as much of the land i s typically in the hands of public owners, the sale of land below market price often constitutes an additional subsidy to local investors. However there i s a number of disadvantages relating to these instruments: the tax rate i s small, and the valuation of the tax base below market value, which reduces its fiscal stimulus; the revenue i s assigned to municipalities, which have to bear the fiscal costs; and it encourages horizontal fiscal competition among regional governments, including municipalities, especially with regard to various forms of subsidizing land ownership, including preferential sales of land. 5.26 The main disadvantage of this instrument appears to reside in its burden on the local public sector. In order to support economic development, the region and its municipalities must be in a position to finance local public services and infrastructure investment. This ability i s undermined by the exoneration from the local real estate tax. 5.27 A preferable option would be to standardize local property taxation and render the tax paid to local jurisdictions creditable against the national business income tax at the standard rate. This would allow combining a revenue-neutral policy for local governments, maintaining their ability to finance local public service delivery and investment, together with a regionally focused national tax policy that avoids horizontal tax competition and tax arbitrage. Wage subsidy 5.28 Workers located in the zones I, and XII, and the provinces of ChiloC and Palena, XI benefit from a tax benefit on their effective wages (Law Decree 889). It was introduced to subsidize employment in the private sector in line with the wage bonus obtained b y civil servants of the public sector in these regions. The subsidy stems from declaring a part of the wage, which corresponds to a "gratification" in compensation for higher costs of living in these regions, protected against personal income taxation (both for the wage tax and the complementary global income tax). The benefit i s limited by employee; so lower wage categories profit more in relative terms than higher wages, which entails a bias against highly qualified services in the regions. The tax benefit i s also applicable to passive income of pensioners living inthe regions. 5.29 The wage subsidy makes sense to the extent that the costs of living might differ significantly from the rest of the country. It constitutes an element of "fairness" and of social protection, but it i s also an economic compensation for economically depressed regions thus creating a "level playing field" for the labor market of dependent and independent workers and employees. However one could easily extend the argument to all regions of Chile, notjust the extreme zones, which would reveal its limitations as to its technical feasibility and economic substance. It i s obvious that effective employment incentives can only operate "at the margin", which i s not true for a wage subsidy that applies to all labor. Infact the latter constitutes a (weighted) subsidy to the wage bill of employers, and does not necessarily operate at the individual level. 50 5.30 Moreover, given that investment i s also subsidized in the extreme regions, the wage subsidy does not necessarily drive a wedge between the prices of labor and capita. And the "wedge'" should also be different for various types of labor in order to foster efficiency: small for low-mobility employment, and large for high-mobility jobs and new employment. This i s impossible to be put in practice. The effect of the existing wage subsidy on creating new employment must therefore be questioned. 5.31 Inthe modernknowledge-based economy, wage subsidies via the income tax system might indeed emerge more systematically. But they must be based on clear objectives and firm quantitative assessment criteria. As will become clear when discussing the wage bonus for public employees, the wage subsidy instruments chosen in Chile have a number of drawbacks that should be eliminated: they reward existing and new employment indiscriminately; they show prejudice against high-value creating labor; they do not necessarily reflect the differences in the costs of living in an objective manner; and they are onerous in terms of surveillance costs for taxpayer migrants. But in principle there i s a case for retaining the wage subsidy3*provided that its benefit i s commensurate with the cost-of- living differential to the centre and i s properly adjusted -reduced inthe North, and increased for high-skilled labor - which could even be effected in a revenue-neutral manner. One could also think of subsidizing not only active labor in accordance to their value added in the regions (including CEOs and councilors who are now excluded), but also human capital creation, Le., vocational training and education. This could eventually be done at the level of the firm, not at the individual level. 5.32 Another line of criticism concerns the relative high costs of wage subsidies and the fact that they tend to flow to the larger and fast growing regions, which i s deemed to be counter-productive in terms of social justice. This critique i s unjustified from an economic point of view. An incentive-oriented wage subsidy must reward high value added creation; hence focus on skilled workers and professionals, which implicitly fosters the dynamic regions. Where social justice matters, this should be addressed at the individual level with targeted social protection instruments based on objective criteria o f need and precariousness. This latter type of policy based on individuals must not be confused with a growth-oriented development strategy based on the payroll of firms. 5.33 As to pensioners it would seem to make sense to eliminate altogether the tax benefit on their passive pensions, but introduce a corresponding subsidy to their active old-age pension contributions while working in extreme regions. This subsidy would be reflected in the level of their pensions later on, irrespective of where they decide to live. It would eliminate the need to monitor and regulate tax-induced internal migration. 5.34 International Ex~erience.~~ Employment subsidies have rarely been targeted at regions. One exception i s the UK, which introduced a wage subsidy in 1967 for all employees inthe manufacturing sector indesignated assisted areas. This lasted for a decade before being abandoned due to opposition from its Europeanpartners on the grounds that it gave the UK an unfair competitive advantage. More typically, marginal employment subsidies (MES) have 38 There i s a need to improve its design. 39World Bank, 2002. Regional Development Policies, Theory and a Review of the Evidence, Maranhao, Brazil. 51 been used in developed countries to reduce long-term unemployment following major recessions. Regional employment subsidies have also been used to support the re-employment of long-term unemployed workers in France, Italy and Sweden. Evaluations of these schemes have indicated some success in terms of job creation and cost effectiveness (OECD 1982). Other studies are not so optimistic. Bohm and Lind (1993), for example, find that the reduction in payroll taxes in the depressed region of Norrbotten (the northernmost county in Sweden) had no discernible effect on employment compared to the same industries outside of the region.40 5.35 The evidence on regional employment subsidies i s much thinner although such subsidies have been used at various times in a number of countries including, the U.SA. (by both national and state governments), France, Italy, South Africa, Sweden and the U.K. The results, thus far, have been mixed. 5.36 Created regional employment may simply displace employment elsewhere in the economy and displacement effects are likely to be considerable. Studies evaluating MES schemes in the USA, UK and France, for example, suggest that subsidies generated only about 20-40 percent of the jobs created intargeted industries (OECD 1982). 5.37 Employment subsidies may become a fiscal burden. Its cost, however, may be at least partly offset b y increased revenue from greater economic activity as employment increases. Fiscal constraints are also less of problem if marginal subsidies are used. 5.38 The efficiency of subsidy schemes i s often questioned because of the existence of non-additional employment and deadweight spending. Non-additional employment refers to the number of jobs that would have been created without the subsidy. Deadweight spending refers to gains to firms that benefit from the subsidies. Several studies have estimated that non-additionality and deadweight spending can result in substantial inefficiencies (see Table 5.1). Other studies are less pessimistic (Wren 2002). Table5.1. DeadweightSpendingand/or Non-AdditionalEmployment Countries Non-additional employment or Studies deadweight spending (percent of total cost of subsidies andor total amount of subsidizedjobs) Ireland 70 Breenand Halpin (1989) UK 63-80 Disney et al. (1992) UK 40-90 Foley (1992) Netherlands 40 de Koning (1993) Belgium 53 Van der Linden (1995) Source: Picard, P.M. (2001). 40 For more details see annex C. Capital vs. Employment Subsidies. 52 Investment tax credit 5.39 Chile employs not only wage subsidies, but subsidizes capital formation as well. This comes in various forms the more important of which is a generalized investment tax credit (Laws 19420, or "Ley Arica", and 19606, "Ley Austral"). These credits apply only to physical investments inthese regions that are affected by companies subject to the income tax (Primeru Cutegoria). Credits are limited up to the year 2008, but can be carried forward to 2030. There are different rates for different projects, with declining marginal incentives (regressive rates). 5.40 The legislation i s extremely detailed in defining various types of investment, excluding for instance primary production, mineral extraction, and commercial activities from the tax benefits. The basic criterion for qualifying i s that there must be a "transformation" process related to physical investment. But there i s also a host of specific rules applying to motor vehicles, boats, and airplanes; to residential and non-residential buildings; to different types of machinery by different types o f projects; to different types of financing; and in accordance to the completion date. Moreover there are provisions that prohibit the sale of subsidized assets before a minimum gestation period (5 years) and the law contains various forms of sanctions. It i s obvious that these rules are extremely onerous in terms of administration, and they carry large compliance and surveillance costs that are often incommensurate with the benefits implied, especially for smaller firms and investment projects. The legislation also provides a large number of loopholes for maximizing the fiscal benefit under varying tax rates that range (at the margin) from 10to 40 percent. 5.41 The purpose of the investment tax credit i s to leverage a low return on regional investment that i s deemed to produce higher social returns for the nation as a whole. This argument i s more pervasive for the South than for the North. So the investment tax credit could eventually be eliminated in the Northern region. Though it would be possible to challenge the wisdom of investment subsidies more generally, especially where there are also wage subsidies, at least the investment tax credit constitutes an effective instrument to foster local investment and to reward it on the basis of taxable economic return.41 5.42 This incentive does not target additional employment, but rather subsidizes consumption of goods. Though, the long carry-forward provision in the regulation aims at start-up business, new business will not increase their investments significantly, as they are more likely facing a cash-flow problem, rather than being interested in reducing the taxable income. Also the high minimum amount favors large business over small and medium enterprises, who would be the more effectivejob creators. 5.43 If the rationale for an investment subsidy is accepted, there is still a number of options to improve the instrument: 41There i s no statistical analysis presented in this report regarding its effectiveness, and, international evidence i s not conclusive. Studies about investment decisions have demonstrated that these exonerations are one of the elements and not the most important, that private agents consider when investing. On the other hand, some of the effects have been smaller when fostering development. (e.g.,Messo Giorno). Also, this incentive violates the equal opportunity principle. 53 Itwould make sense to use a larger definition of physical asset formation andto do away with overly specific rules based on projects and other criteria that interfere in the free play of market forces and invite taxpayers to play games against the loopholes inthe law. The differentiation of rates for the tax credits as well as their regressivity should yield to a uniformrate that relinquishes excessive "fine tuning". The standard rate could also be much lower (say, 20 percent) than the highest existing rate (40 percent). The minimumamount of investment could be much lower to enable smaller enterprises to benefit from the tax credit. There should be a ceiling on the carry forward over time, say a maximum of eight years (instead of the fixed time horizon now). The tax credit could be eliminated for the North over time, as the rationale for this region i s less clear than for the South. 5.44 Znternational E~perience.~~ Value and Eligibility of Major Investment Incentives in EU Countries are summarized in table 5.2. Although studies evaluating the effectiveness of these incentives do not provide unambiguous findings, several conclusions can nevertheless be drawn. 5.45 Regional investment incentives can increase investment, employment and output in lagging regions. A number of empirical studies using regional time series data in various countries have explored the effects of regional investment incentives by estimating investment or factor demand equations. Most studies test dynamic investment or employment functions (Faini and Schianterelli 1987; Wren 1994, Daly et al. 1993). While quantitative estimates vary considerably across these studies, there i s some evidence that investment incentives impact positively in lagging regions with the expected bias towards increased capital intensity. There i s less evidence of the impact of investment incentives for developing economies. In Pakistan, investment incentives successfully diverted investment from developed to less developed areas but failed to generate any additional investment (Pasha and Bengali 1985). Furthermore, investment was only diverted to areas situated fairly close to Karachi, the leading commercial and industrial center. 5.46 Investment incentives have helped to generate morejobs in small firms. Small firms are more labor intensive than large firms, which means that subsidizing investment in small firms can be expected to generate morejobs for any given amount of grant aid. The problem with small firms, however, i s that they have a higher failure rate than large firms, thus reducing the advantage o f directing grants towards the small firm sector (Wren 1998). 5.47 Incentives might not have permanent effects unless maintained indefinitely. Some studies have found that the positive impact of investment incentives i s only temporary and in 42World Bank, 2002. Regional Development Policies. Theory and a Review of the Evidence, Maranhao, Brazil. 54 some circumstances may be reversed when they are removed (Wren 1994). A study of Puerto Rico, for example, failed to find evidence of a significant impact of investment incentives on the location decisions of firms. Guimaraes et al. (1998) argued that incentives were "likely to be too temporary to be worth takingup inthe first place." 5.48 The cost-effectiveness of regional investment incentives depends upon the conditions imposed on the grant recipient. Empirical research has shown that regional investment incentives can be very cost effective provided they are linked to the number of jobs to be created. In the UK, for example, automatic investment grants were found to have a very high cost-per-job because they were being obtained by capital-intensive firms. Automatic investment grants were consequently abolished for large firms. Grants are now awarded only if the investment creates (or safeguards) a sufficient number of jobs. Strict criteria are laid down so that the payment of a grant i s subject to the `projected number ofjobs actually being generated. Surveys of the firms receiving discretionary investment grants inthe UK indicate that the `deadweight' element in these grants has been relatively small. (Wren 2002), for example, estimated that only 20 percent of the projects receiving grants would have gone ahead without the grant beingawarded and the cost perjob year i s about one-third of the annual unemployment benefit. The cost effectiveness of investment incentives does vary considerably, however, according to the criteria laid down by the government (Daly et al. 1993). Table 5.2. Value and Eligibility of Major InvestmentIncentives inEUCountries, 1992 Country Incentive Eligibility Belgium Investment Wallonia and grant 21 percent of eligible Flanders Interest expenditure subsidy France Regional FF35,000 perjob created in PAT designated policy grant standard award zones and FF areas which covers (PAT) 50,000 perjob created in most of France maximum award zone. In except the Paris addition, for manufacturing Basin and Lyon (3) projects, a ceiling set as a percentage of eligible expenditure - 17 percent in standard zones and 25 percent in maximum award zones. Local business A 100 percent exemption from Covers most of tax concession local business liabilities for 5 France, except the years Paris basin and Lyon. 55 (con't. Table 5. F Incentive Administrative Value Eligibility Discretion (1) Investment D 10-30 percent investment 3ast Germany and Grant :osts 3ther areas A 4vailable only in Special 40 percent of immovable Zonal Border Area. Depreciation assets (Le. building) and 50 Allowance percent of movable assets (Le. plant and machinery). ERP Regional A Upto 50 percent of eligible Small to medium Soft Loans investment, with maximum Firms engagedin ceiling of DM300,0000. No local services, e.g., interest-free period. Loan wholesale and retail duration varies - 10years for trades, restaurants, plant and 15 years for :tc. building. Principal repayment holiday of 2 years. Investment A (4) 15-56 percent of investment Mezzogiorno. Grant costs Soft Loans/ A 64 percent interest reduction Awards larger to Interest on 10-15 year loans with 3-5 small firms. Subsidy year principal repayment (National Fund holiday. Loan principal covers Scheme) 40 percent of investment. Social Security A 100percent concession on Concession employer social security contributions for additional labor hired for 10years. Concessions 100percent on local taxes on local and 100percent onprofits taxes national profits for 10years. taxes SIBR Industrial policy component: Most of Portugal, 20-45 percent of investment except the coastal costs. strip between Lisbon Location component: 15 and Oporto. percent of investment costs (with an additional 10 percent iflocatedinintegrated action zones for regional SIFIT development). SIPE Employment component: 300- 600,000 escudosper job subject to a ceiling of 10 percent of investment cost. Maximum of 60 percent of investment cost. Maximum of 50 percent in Lisbon and Oporto and 70 percent elsewhere. 56 on't. Table 5.2: Country Incentive Administrative Value Eligibility Discretion (1) Regional D (7) Maximum of 50 percent of Designated Areas Investment investment cost in the main Grant Designated Areas, Zones of Economic Promotion, and maximumof 75 percent in Zones of Industrial Decline. Sweeden Investment D 20-35 percent of investment Assisted Areas. Grant costs. Subject to cost-per-job D limit Employment Maximum of Skr 120,000 to Grant 200,000 payable over 5 years. Developmen A/D 50 percent of intangible t Grants investments (product development, marketing etc.), subject to maximum of Skr 500,000 per project. U.K. Regional Minimumneededby project. Assisted Areas in Selective Great Britain. Assistance Regional 1.5 percent invest. Costs Small firms (<25 Enterprise (subject to maximum of employees) in Grants &lS,OOO) + SO percent Development Areas. product development (subject to maximum of &2S,OOO) Selective 30 percent plus discretionary Northern Ireland Assistance 20 percent Source: Joumal of RegionalPolicy. SpecialIssue.Vol. 12. 1992. Notes: ' Discretionon the part of the authorities to decide whether or not to award, and to decide on the rate of the award. Discretion enables the award to be tailored to the needs of the region and the applicant. It avoids inefficient use of public funds. "A" denotes little or no administrative discretion inaward, rates fixed. "D' denotes administrative discretion in award, rates up to a maximum. 'In Wallonia, ratesofawardsaredeterminedby bothquantitativecriteria(under which awards areautomatic, dependingonjob creationand value added per job) and qualitative criteria (under which awards are discretionary). InFlanders, there i s discretion in the award decision (focusing mainly on project viability); thereafter awards are largely predictable, though the discretionary "strategic importance" component has recently increased from 3 to 6 percent of eligible expenditure. Distinction i s made between maximum rate zones and standard award zones for manufacturing projects. Projects in areas of serious unemployment problems outside of the PAT-designated area were classified as standardaward zones. While the Capital Grant i s basically automatic in character, the First and Third Implementation plans made provision for so-called `planned bargaining', under which there i s discretion to award the maximum possible Capital Grant (irrespective of project sector or location) to major industrialgroups establishinginnovative projects in the Mezzogiomo, large individual firms andcertain consortia of small and medium-sized f i I n l S . For setting up projects with up to Fl 18million of eligible investment (Fl 8 million for extensions), rates of award for are fixed and conditions of awards are overt. Incontrast, for setting up projects with more than Fl 18 million (Fl 8 million for extension), awards in the three northemprovinces in excess of the automatic maximum are wholly discretionary. Inthe Transitional Areas, the equivalent limits are Fl 30 million for setting upprojects and F175 millionfor extensions within 5 years of settingup. Systems are overt. Applicants should know whether or not they will receive an award and also within what percentage range that award i s likely to fall. There is, however, discretion regarding the actual percentageaward made. 'Although basically discretionary, in certain zones a proportion of the award is determinedautomatically by employment created. 57 Development Fund(Fondo de Foment0 y Desarrollo) and investment subsidy 5.49 The Law Decree No. 3529 has created a Development Fund, which was rendered operational through a decree (DFL No. 15) by the Ministry of Finance. It provides an investment subsidy to small and medium enterprises of benefiting regions whose annual turnover i s below a certain limit. The amount of the investment i s subject to a ceiling and has to be effectedwithin the respective region. 5.50 The rules guiding the Development Fund, the definition of qualifying investments and investors, and the procedural canon relating to the valuation, certification, registration, and timing of investments as well as the allocation of investment subsidies from a (closed) fund are cumbersome and overly specific, which renders the instrument highly non- transparent. Moreover, the subsidy i s allocated only ex post, i.e. after the investment has been effected. There i s no legal entitlement, but the projects are subject to scrutiny by a "Comite` Resolutive" composed of regional representatives of various Ministries, and of local entrepreneurs. This procedure, together with the non-transparent definition of promotional activities and administrative "red tape" render the process of subsidy allocation highly arbitrary and haphazard - at least inthe eyes of potential applicants. 5.51 From an economic point of view economic incentives can only work under transparency and rule of law. The investment subsidy i s accorded to investors only ex post and in an ad hoc fashion that investors must consider a "lottery". Thus the effect of this instrument i s likely to be nil, and the funds allocated through the Fundrepresent a waste of public resources at best, and a source of potential corruption at worst. This i s why it should be abolished without replacement. TARGETED, DIFFERENTIATEDPOLICIES FOR THE NORTH AND THE SOUTH: FROM "ZONAS EXTREMAS" TO "ZONAS ESTRATEGICAS" The Need for Reformand Basic Policy Options 5.52 The findings of the present study on ZE policies in Chile lend themselves to the following policy conclusions that justify the search for alternative policy options: 5.53 There i s no coherent concept or policy targeted toward "extreme zones". The different pieces of legislation examined constitute rather a patchwork of single policy measures reflecting the result of geopolitical considerations or political pressure by local interest groups over time. 5.54 The dispersed legislation i s highly complex and difficult to understand by public officials and parliamentarians, except those in the benefiting zones (who have developed specific proficiency in rent seeking and keeping). This complexity adds to preserving the benefits of regional groups and renders it difficult to adjust regional policy instruments, or even phase them out. 58 5.55 The regional policy i s caught in a "prisoners' dilemma", especially in the case of free-trade zones, which tends to keep these instruments in place just because neighboring countries do the same-even though their dismantling would benefit both Chile and its neighbors from an efficiency point of view. 5.56 While the geographical, demographic, economic, and social characteristics of the North and the South of Chile vary considerably, the ZE policies do not appear to take this appropriately into account by effectively targeting the policy instruments to their specific regional needs and requirements. 5.57 The remainder two sections of this Chapter propose two sets of policy measures that would be worth pursuing if Chile wants to develop either a more precise or a more cohesive and comprehensive set of policy options: 5.58 The first set of policy measures concerns a targeted approach toward developing the North and South in a differentiated way by taking their respective, and significantly different, growth potentials into account. The second group of policy options will demonstrate the need of, and possible ways toward, a more coherent and dynamic regional policy for the whole of Chile, not just for the (now) "Zonas Extremas". 5.59 The above, more ambitious sets of policy options developed in the remainder of this Chapter require a note of caution. As evidenced in previous chapters, it will be difficult to change the direction of ZE policies drastically unless there i s a compensation for the loss of existing benefits. And there must be the prospect for regional growth policies targeted toward developing the ZEs in a more coherent and strategic fashion. It i s unlikely that the fiscal costs could be reduced significantly inthe short run. This might, again, contribute to paralysing the policy machinery, as spectacular short-term gains are unlikely to come forth. However significant benefits will be reaped in a longer term, both in terms of reduced fiscal costs and economic development, which render policy action highly profitable. The ultimate aim must be to overcome the static concept of "extreme zones" in favor of a more dynamic perception of "strategic zones" or "strategic regions". Developingan economic growth strategy for the North. Toward an Enterprise Gateway inRegionI 5.60 Underlying the performance of Tarapacii (Region I) the last quarter century was over the deliberate linkingof a Zona Franca or tariff-free zone with zero or concessionary tax rates on the one hand and employment and investment incentives on the other. In the high-tax, high-tariff era of the 1970s, this constellation of policies was testament to creative Chilean statecraft - generating a set of incentives that was in harmony with, and indeed anticipated, the manner in which the global economy was about to evolve. Although never explicitly addressed inthe many interviews, it would not seem to be much of a leap to suggest that Chile today might not be among the world's pre-eminent free traders were it not for this creative experimentation with Zonas FrancadZonas Extremas. However, as emphasized earlier in the report, the generalized movement toward lower tariffs in tandem with Chile's impressive array of free trade agreements has served to undercut much of the advantage of an import- oriented, tariff-free zone. Fortunately, drawing on existing studiedresearch (e.g., JICA et al, 59 2001), on information and evidence provided during the site trip to TarapacB, and on the team's own deliberations the analysis indicates that a promising economic future i s emerging for Region I- as an Enterprise Gateway which would drive off Chile's natural endowments and policy strengths as well as Region 1's strategic location as a natural global gateway to the Pacific Rim, including positioning itself as a Pacific portal and economic nucleus for the cross-border economies of Peru and Bolivia and even partsof Mercosur. 5.61 For Region Ito be able to take advantage of this strategic geographical and economic location, several elements would have to fall into place. The trade and economic linkages among Chile (Region I), Bolivia and Peru would need to be secured via a three- country free trade agreement or, perhaps, via the FTAA. Chile would need to play a lead role here because while Iquique and Arica are obvious gateways to the Pacific for Bolivia and Mercosur, they are not unique - Peru has recently privileged its port city Tacna --ZOTAC- ILO in an attempt to redirect area commerce through Peru. Second, Region Imust be able to capitalize on its strategic location as the potential port of first entry, of transhipment or of value-added re-exports for the products of China and the Western Pacific. Inrelation, Region Iwoulddonthemantleofanexportandvalue-addedPacificRimplatformforgoodsfromthe trans-border area (e.g., wood products from Bolivia and agricultural products from Mercosur). Toward these ends, the transportation facilities and physical infrastructure would need to be upgraded, including modernization of the ports of Iquique and Arica and the access routes through to Mercosur. 5.62 Turning now to the "enterprise" aspect of the Enterprise Gateway, and continuing with the list of requisites for success, the industrial potential for Region Ilies in large measure in value-added export and re-export activities, presumably anchored around small and medium-sized enterprises. To bring this to fruition Region Iwill have to achieve the administrative and managerial flexibility and efficiency characteristic of best practice elsewhere. One aspect of this would be to build upon existing infrastructure (e.& ZOFRI) to create a logistics and services centre for Region Ienterprises, whether domestic or foreign. This would cover finance, insurance, communication, shipping, and customs among other areas. Relatedly, the Enterprise Gateway would require transparent, streamlined, and efficient regulatory provisions that would also match best-enterprise-zone practice anywhere, e.g., with respect to incorporation of firms, movement of personnel, inward foreign investment and the like. This means that the Enterprise Gateway governance structure must focus first on capacity building at the local level and then have some meaningful degree of local-regional autonomy and not simply be an extension of Santiago: Not only must the central government and the Intendentelregional government make room for inputs form the provinces, municipalities, business, civil society and other stakeholders, but this must also extend to ensuring that mechanisms are in place to horizontally coordinate/ integrate the various policies and incentives. 5.63 Since this vision involves transforming Region Ifrom a Zona Franca (essentially an import platform for the rest of Chile and low value-added re-exporting) to an Enterprise Gateway (focusing on value-added manufacturing and exporting to the Pacific Rim), the policies and incentives appropriate for Region Imust likewise be transformative. This means shifting away from Ley 889 with its tilt towards intra-marginal and lower-skilled employment and toward CORFO-type incentives which favor new jobs, in new industries, for new markets 60 as befits the transition from a Zona Extrema to an Enterprise Gateway or Zona Estratkgica. Much more consistent with the latter would be to follow practice in other designated enterprise or financial zones of granting, say, a five-year tax holiday for highly qualified professionals or investors to bring their expertise to both the logistics and production needs of Region I. 5.64 This broaches the difficult political issue of whether Region Iwould continue to be privileged by the designation of an extreme zone. Rather than register an opinion on this, the study prefers to offer a few observations. The first of these is that if a decision is made to continue ZE-type incentives, there i s ample scope for a revenue-neutral transformation towards policies appropriate to an Enterprise Gateway. Beyond the funds that can be re- allocated from Ley 889, the civil service wage grid for Region Ii s also excessive. Likewise the regional and municipal transfers exceed the levels required to generate Chilean-average social and economic indicators for Region I.Repackagingthese and other monies in terms of priorities and incentives compatible with the Enterprise Gateway might provide the needed funding. A second observation is that the concept of an EnterpriseGateway for Region Iis a positive-sumeconomic strategy for Chile. Positioning Iquique and Arica, as Pacific gateways will create jobs and income that will not be at the expense of other regions. This observation i s relevant to the request in the Terms of Reference for the report to assess whether Region I or Iquique should be designated as an Information Technology (IT) zone, replete with accompanying incentives. While the Enterprise Gateway obviously requires access to state- of-the-art IT, privileging Region Iin this regard i s likely to be a zero-sum game at best, since it is almost certain to inflict significant costs on the Santiago-Valparaiso area which i s arguably the region that would have the comparative advantage in terms of garnering returns from deepening IT infrastructure and access. Finally, some of what might otherwise fall under a Zonas Extremas type of approach to the Enterprise Gateway (e.g., modernizing the ports of Iquique and Arica) may well be appropriate policy in their own right, as part of an overall export development strategy for Chile for example. 5.65 B y way o f a concluding comment, while the Zonas Extremas policies over the last quarter of the last century, contributed to positioning Iquique/Arica, in general Region I,to recognize and to take advantage of the potential development, which i s now associated with an Enterprise Gateway; this development strategy for Region Inow exists quite independently of whether ZE-type policies remain inplace. Enhancing regional policiesfor the South 5.66 The southern most regions, Region XI and XII, are also referred to as the Austral Zone. This joint area distinguishes itself from the other Regions through its remote and isolated position. The physical structure, especially in the northern part of Region XI, of fjords, glaciers, channels and islands, creates a difficult environment for a permanent land link to the northern Regions. However, the unique climate in the area, combined with the marine life and beautiful mountain landscape creates exceptional tourism and fisheries opportunities. 5.67 The accomplishments of the government in developing social infrastructure and overall living conditions in these two regions are outstanding, considering the difficult 61 circumstance. However, the type and extent of the support does not appear to be sustainable in the long run. The marginal return for infrastructure investments within Chile i s decreasing rapidly, and providing adequate domestic transportation infrastructure within and to the area cannot be financed under the current strategy. 5.68 Additionally, the present composition o f the regional economy indicates that structural changes are required to ensure regional economic growth or even stability. Table 5.3 shows that the productive sectors of Region XI are mainly fisheries and agriculture, whereas the concentration in Region XI1i s mining. Though both Regions seem to be different inthis respect, both require further sector diversification to minimize economic vulnerability. The common lack of tourism or other value adding services i s striking. Paradoxically, it i s the geographical situation of these two regions that makes it difficult to access while at the same time creates a unique opportunity for eco-tourism or biological research. Table 5.3. Composition of the RegionalEconomy (percent) Sector RegionXI RegionXI1 Agriculture and Forestry 5 2 454 Fisheries 15,7 7,8 Mining and Manufacturing 6.5 29.5 Utilities 4,1 3 s Construction 11,l 61 Trade 11,4 14,7 Transport and Communications 7 8 6 4 Financial Services 9 3 9 2 Other Services 29,2 18,4 5.69 The outlook on the economic side for the Regions i s promising, if certain goals can be achieved. The future strategy for the Region needs to address two issues. For one, the traditional sector needs to be strengthened in order to maintain the livelihood of the population, and provide a sustainable development. On the other hand the diversification of the economy through opening of the market and access to international markets i s important for significant growth. The Region's economy relies heavily on micro enterprises, which need the link to other markets, technology and credit to sustain and grow. Most importantly i s the reduction of transportation costs and time. Permanent subsidies are neither efficient nor sustainable from the fiscal perspective. Thus, the support and implementation of the Plan Austral i s the most sensible solution to the major problem of the Regions. 5.70 The Plan Austral would facilitate and further develop land access between Chile and Argentina. It would also exploit economies of scale in the promotion and delivery o f tourist packages. Both, Argentina and Chile depend on the free and secure transit of goods and persons through each other's territory, to ensure sustainable development in their respective southern parts of the country. Regional integration would benefit both countries, and the spill over effects of trade and tourism would ensure a strong local economy. Certainly it i s 62 recognized that such a regional economy would require significant political concessions on both sides. PREPARINGTHE GROUNDFOR LONG-TERMECONOMIC GROWTHAND PROSPERITY 5.71 Towards a dynamic, poverty-focusedregional policy for the whole of Chile (not just for the ZEs) Anti-poverty focused, growth-oriented regional policies 5.72 As was discussed earlier, a more dynamic and aggressive approach to developing the extreme zones with the aim of converting them into strategic spearheads of the country i s to be preferred over the existing static and defensive attitude of the ZE policies. The approach would also have to be more focused on regional growth and poverty alleviation. This new policy attitude could eventually become a more generalized regional policy for the whole of the Chilean national territory and its zones. 5.73 A consistent and result-oriented regional policy needs performance indicators and benchmarks against which the success of regional policies can be measured. It would also allow the regions to "graduate", i.e. emerge from being subsidized to becoming self-sufficient and self-maintained, possibly even contributing a net fiscal surplus to the national budget. These performance indicators should be anti-poverty focused, and growth- and export- oriented. Anti-povertyfocused regionalpolicy 5.74 Anti-poverty focused regional policy does not mean simply supporting private consumption to the poor in a region. This might also be necessary, but it should be pursued with other than regional policy instruments, for instance personalized benefits through social assistance based on indices of individual economic deficiency or precariousness. An anti- poverty focused regional policy must aim at assisting the region and its residents to move out of poverty, which a pure alimentation of local private consumption can never achieve. On the contrary: subsidizing local consumption will create economic and social dependencies, foster rent-seeking behaviour, discourage entrepreneurial behaviour and risk taking, and keep the local economy caught in a poverty trap for ever. 5.75 Moving a region out of a poverty trap requires substantial public investments in local infrastructure and service delivery. For instance the concept of a "gateway" function for zone North requires strategic road construction, coordinated with neighboring countries, the modernization of harbours, effective local public services (such as customs clearance), and auxiliary local infrastructure ranging from kindergartens, schools, hospitals, and recreational facilities to attract highly qualified professionals and private investors. It might also require stronger involvement of local citizens and interested groups in order to gear these resources to their most effective use. 63 5.76 Notwithstanding the need for fixed-public-capital formation, regional policy instruments to combat poverty must however emphasize human capital formation. Human capital will be over time, probably more than fixed capital, strategic for the modern, service- oriented economy of the 21st century. But human capital i s equally indispensable for raising productivity in more traditional sectors such as agriculture, fishing, mining, and industry. The modern Chilean state has inherited an education system that might now be tilted toward favoring the capital city (Santiago) and adjacent regions, but it has also been striving for long to improve the quality of human resource development in the extreme regions-with remarkable success. It i s now time to expand that policy to the whole of the nation and in a more consistent, targeted national education offensive. 5.77 Such an offensive must be embedded in a coherent regional policy framework in order to be effective. Given limited public resources it would be vain to dissipate all efforts for the sake of equality. The strength of the Chilean economy and society lies in the diversity of its regions. So human resource building should respect regional characteristics and be focused on developing their potentials inorder to be the most effective. So if a region, such as Region I,i s expected to develop into a "Pacific Gateway" for central South American countries, a Research School for Logistics could form a crystallizing pole of excellence43that would contribute to developing local human capital and attract scholars from all over the world. However, coordination schemes should be in place in order to supply the demand for education - private or public-private partnerships. It would form the basis of a service industry that will sustain the region as it graduates from being at the mercy of Santiago into a self-sustaining growth pole. In the South, there i s likely to be a need to concentrate higher education and research in fishery, ecological and tourist-related services, in addition to investing inthe local infrastructure. Growth oriented regionalpolicy 5.78 The growth and export orientation of regional policies will mean a significant shift in the paradigm of ZE policies. Rather than taking a defensive, alimenting and preserving stance that keep the regions "at the mercy" of the national government, a growth oriented approach must be aggressive and constructive at the same time. It would also have to incorporate incentives for a region moving out of a supportive scheme, i.e., "graduate" from being a recipient of support to becoming a self-supportingentity. 5.79 The regional policy of the EU might have had its successes and failures, pending mainly on the governance of recipient agencies, but it has a number of structural elements that mustbe considered apposite incentives for regional policies: 43 For example, Government support for knowledge networks or Centers of Excellence in Bavaria, Germany has either created or extended international-level competence in different research areas and increased their economic application. For certain sectors, the Centers of Excellence are usually independent units affiliated with universities and research institutes. On the other hand, the temporary Finland Center of Excellence aims at improving the preconditions for internationally competitive industry and business calling for a high level of expertise. I t was drawn up jointly by representatives from ministries, local government, pre-existent technology centers, the universities and the industrial sector. There are also four centers of this kind in the Netherlands, which are mostly funded by international investment. (Sprenger, 2001). 64 0 Regions are formed on the basis of criteria reflecting the specifics of the regional economy. They are typically larger than municipalities, and smaller than regional governments or provinces. It thus avoids the risk of selecting "regions" that represent personal political "turf" of local officials and representatives. Regions are classified according to an objective criterion of necessity (75 percent of average per-capita income). Only those falling below this threshold qualify for support. This i s a dynamic rather than a static concept, because "poor" regions are allowed to mature over time thereby losing their privilege (after a transition period), while other regions might newly qualify for support. Thus support to a region i s not eternalised-as appears to be the case inthe Chilean ZE policy. 0 The regional policy of the EUi s mainly focused on supporting regional infrastructure investment (and, to a minor extent, human capital formation). It uses the instrument of co-financing regional projects, which requires regions to match the grant and thereby express their individual preferences in the light of their own budget restriction. It also requires the regions to possess sufficient own revenue to match the funding supplied by the EU.44 Support i s mainly b y projects, which implies an ending of the specific support once a project i s concluded. This embeds an automatic "sunset clause"; of course new projects can be defined that provide continuing support to a region. 5.80 A more comprehensive, anti-poverty focused, growth-oriented regional policy of the Chilean government would represent a novel approach toward developing regional economies and a major shift in emphasis. It i s also likely to require additional resources as new regions might qualify for support if based on reliable and objective criteria of need, while existing benefits, notably those flowing to the extreme regions, cannot be phased out swiftly. There i s thus need for a thorough analysis of long-term growth potentials of the Chilean economy by region, a clear definition of strategic objectives for each situation, including an adequate and incentive-compatible design of instruments to reach these objectives. It i s hoped that the Chilean authorities will embark on this thorny political road to secure and develop the growth potential of the economy, and to promote the prosperity of its citizens over a longer run.45 44 This is of course always true for a sovereign national government, as for European member states that possess their own tax base. Ina national setting, particular inthe case of Chile, regions might not control sufficient own resources to match the funds supplied by a coordinating regional policy at the national level. When member states or regional governments possesstheir own tax base, the design of inter-government fiscal transfers usually includes a national equalization scheme for general revenue grants. The amounts of state grants must be foreseeable and fair; fairness requires the apportionment rules to be non-discriminatory, universal, stable, transparent, and non-arbitrary or separately `negotiable' 45 In this sense,the regional government of Bio Bio, the Ministry of Economy and CORFO have entered into an agreement to program funds to strengthen technological development in the region in an entity called "Innovabiobio."(Fondo de Innovaci6n Ecol6gica de la Regi6n del Bio Bio). I t i s the only fund for regional decision making on innovation in the country. Since April of 2001, it has assigned co-financing funds for 98 projects, generating investments for US$l.lm in 130 firms, mostly in incubators, wood, agro industry, bio tech, manufacturing, fisheries and tourism. Director claims for each dollar invested, 8 are returned in tax receipts. (www.innovabiobio.cl)See annex B for further details on RegionXI. 65 Strengtheningpublic governance inthe regions 5.81 As it has become clear when discussing strategic approaches targeted to regional growth zones, in particular in the North, effective governance in the public sector will be key to success. Public decision-making has to be well informed, proactive, prompt, and positive inline with localpreferences andpotentials. 5.82 Strengthening public governance in the regions has many facets. One relates to the costs of public decision-making. These costs may considerably outweigh the benefits of any gratification given in the form of fiscal benefits, which might annihilate the intended effects of fiscal incentives altogether. Where administrative "red tape", long delays in decision- making, and coyness to take on responsibilities by local officials prevail, international and national investors will be hesitant to commit resources. They then prefer to expand their economic activities closer to the centre of power: the capital Santiago. So one approach would be to deconcentrate public administration even more, with even greater policy discretion given to the lntendentes and regional councils. It would also require a thorough analysis of administrative and procedural rules with the aim of removing "red tape" and accelerating public decision making in order to "free up" local administrative potentials that now remain under exploited or dormant. Deregulation i s mandatory for successful regional strategies. It i s also politically feasible, and would produce much larger benefits that go beyond regional policies; and it would be fully congruent with a unitary constitution, and attuned to a centrist government intending to reform its principal-agent relationships with regional representatives by basing them onto incentive-compatible rules. 5.83 Further developing local and regional capacity would be a first step in order to commit local interests and resources to secure greater civil participation and adequacy of regional policies directed toward genuinely native needs and preferences, which would allow exploiting regional growth potentials in a more systematic, differentiated, and competent fashion. This would require more than just a further deconcentration of powers and greater freedom to act of local public agents: it calls for partial transfer o f responsibilities to regional and municipal self-governing bodies. 5.84 This i s not the place to develop a blueprint for institutional decentralization and the devolution of powers in a unitary government framework. It would go far beyond the terms of reference of this study. So if the Chilean authorities would seriously consider these options, a further inquiry, focusing more closely on given alternatives within the existing constitutional and institutional setting of Chile, would be required. 66 CHAPTER6. SUMMARY OFFINDINGS ANDRECOMMENDATIONS46 6.1 Incentives for the ZE as public policy. Evaluation of the ZE policies appears to be long overdue. The underlying concept of ZE and the policy objectives are diffused, thereby making monitoring and evaluation a nearly impossible technical task. Legislation i s fragmented; instruments have accumulated over time in a patchy, untested way. The dispersed legislation i s highly complex and difficult to understand by public officials and parliamentarians, except those in the benefiting zones (who have developed specific proficiency in rent seeking and keeping). This complexity adds to preserving the benefits of regional groups and renders it difficult to adjust regional policy instruments, or even phase them out. The very idea of cost-benefit or welfare analysis seems to escape the intention of policy makers. It i s hard to identify an implicit logical frame or a program concept behind those policies. 6.2 Besides being prisoner of a geopolitical icon, the ZE policies i s also caught in a "prisoners' dilemma", especially in the case of free-trade zones, which tends to keep these instruments in place just because neighboring countries do the same-even though their dismantling would benefit both Chile and its neighbors from an efficiency point of view. 6.3 The report argues that strengthened governance i s needed for regional policy making while enhanced transparency i s essential for adequate policy monitoring and evaluation. A consistent and result-oriented regional policy needs performance indicators and benchmarks against which the success of regional policies can be measured. It would also allow the regions to "graduate", i.e. emerge from being subsidized to becoming self-sufficient and self- maintained, possibly even contributing a net fiscal surplus to the national budget. These performance indicators should be anti-poverty focused, and growth- and export-oriented. 6.4 Chile appears to be building the necessary basis for regional development policymaking and implementation. The very concept of the regions appears to be evolving towards more pro-growth mandate; the role of regional governments i s gradually expanding, including the possibility of a wide array of public-private partnerships. Government has recently submitted to Congress constitutional and legal reform proposals that would strengthen governance and management capacity of regional governments and would increase the scope for regional development policies. 6.5 The concept. ZE policies were designed, inter alia, to strengthen the administration of the northern and southern most territories, to enhance the economic development of the regions and to increase the standard of living of residents. Presumably, all of this was designed in turn to serve the larger objective of increasing their population and thereby securing their territorial integrity. Not surprisingly, this set of objectives has come to be viewed as an integral part of Chilean nation buildingand, therefore, has taken on the role as a national icon. 46Thischapter draws on the conclusions and recommendations of previous chapters. 67 6.6 Characterization of ZEs. The ZEs share some common features and are at the same time highly different among themselves. Not surprisingly, one of the commonalities i s that the ZEs are very sparsely populated in relation to the rest of Chile. Intriguingly, however, the populations o f the ZE regions are anything but evenly spread over their respective territories. Regions Iand XI1are highly urbanized, indeed remarkably so with ratios of 94.1 percent and 92.6 percent respectively, not far off the 96.9 urbanization ratio for Santiago Metropolitan Region. AysCn i s in the middle group of all Chilean regions in terms of urbanization at just over 80 percent. 6.7 The picture that emerges i s that the ZEs are, in comparison to other regions, small in population, large in terms of territory, highly urbanized, on balance above average interms of regional GDP and more so with respect to household income, amongst the best performers in terms of social indicators, and the recipients of very generous allocations for social expenditures and public investment. This rather enviable picture leads necessarily to rethink, i)whatweretheobjectivesoftheZEspoliciesinthefirstplace,ii)whetherthoseobjectives have been largely achieved or still need to be reached, iii)the convenience of establishing a clear temporary dimension or introducing a programmatic view for these policies, and iv) how compatible those policies are with other social and economic policies of the country. 6.8 While the geographical, demographic, economic, and social characteristics of the North and the South of Chile vary considerably, the ZE policies do not appear to take this appropriately into account by effectively targeting the policy instruments to their specific regional needs and requirements. 6.9 The instruments. The report produced a qualitative analysis -often based upon international experience- and estimated the fiscal cost of each one of the incentives currently applicable to the ZEs. It also addressed the challenge of instrument improvement by responding to the following questions: Do policy instruments remain as effective today as when they were first introduced? Alternatively, did those instruments already reach their peak and are currently less effective or are expected to decline in the near future? How to make current policy instruments more effective or how to enhance their cost/effectiveness? 6.10 A retrospective look at the instruments to promote the ZEs make it evident that the passage of time has rendered some of the incentives obsolete. Other incentives suffer from serious technical weaknesses. The study includes specific recommendations to improve incentive design, were Chile to maintain the core purposes and structure of current ZE policies. The report address the streamlining and refining of existing policy instruments with a view to increasing their effectiveness for a given amount of cost, or to reduce fiscal costs where the benefits of the instrument are considered to be negligible. However, the study emphasized that the policies themselves -not just the instruments-need to be framed with transparency, clarity o f purpose and evaluation mechanisms. 6.11 The costs. The aggregate or overall annual cost of privileged treatment for the three ZE regions is estimated to be US$421.83 million. This total includes the US$209.42 million arising from the fiscal incentives and the roughly equal US$212.41 million arising from preferential ZE allocations from national public expenditure programs. 68 6.12 Given the low density of population, notably in the South, the fiscal costs of the ZE policies are relatively small compared with the total of tax expenditures-thatthe Ministry of Finance has recently estimated to be about 4.3 percent of GDP. Moreover, these costs, which this study has tried to quantify and consolidate for the first time, are highly dispersed as they associate with several instruments. The dispersion of costs by instruments produces non- transparency, which also contributes to protecting individual interests. Tax exemptions appear to be difficult or expensive to control and appear to create room for tax evasion. 6.13 While the direct fiscal costs could be bearable for a country like Chile, the efficiency costs of ZEs might be high, especially in a dynamic perspective. The regional policy instruments now in place are likely to fail producing the structural change needed to sustain economic growth over the longer run. There i s the suspicion that this problem i s more prominent for the North than for the South. Furthermore, the efficiency cost i s compounded by the social opportunity cost of transferring extraordinary resources to regions that are relatively better off. 6.14 The results. The analysis showed that, unlike most other regions and countries, ex- post, the Zonas Extremas did not experience out-migration, significant income differentials or unemployment differentials usually associated with disadvantaged regions. Income analysis and social indicators also point to the conclusion that the ZEs are generally better off. Thus, the overall mix o f policies appears at first glance to have been effective, considering the ex- ante geographical and socio-economic constraint^.^^ 6.15 The set o f fiscal incentives for private enterprises and especially the operations of the Zona Franca were essential to the successful economic lift-off experienced by Region I, whereas the set of preferential regional allocations of public social and investment transferdexpenditures were at least a contributing factor to the emergence of the superb social infrastructure and social performance of Regions XI and XI1 and especially the latter. Note that this i s not to take sides on: i)the precise causal linkages between policy instruments and results -as if no other factors outside the ZE policies also contributed to the results, or ii) whether those instruments or those objectives are still current. As a matter of fact, the study strongly recommends that ZE policies be framed within the new context of the information era where social policy (human capital formation) and traditional economic policy are both essential ingredients for achieving international competitiveness. 6.16 Analysis and recommendations. Four observations appear appropriate regarding current ZE policies. The first i s that a not-insignificant part of the large transfers flowing to the southern ZE regions can be rationalized on cost-of-living differences and cost-of- construction differences. Second, it i s generally the case that developed nations with "extreme" regions spend much more in the way of transfers on them, relative to what the regular regions receive. The third observation i s that continuing with ZE policies i s in the context of 2003 much more important for the southern ZE regions than it i s for the northern ZE. Region Ihas a chance to lever its current strengths into a Pacific gateway role that will allow growing out of its ZE-policy dependency. Regions XI and XI1have no such prospects. 47Note that the effectiveness i s not demonstrated statistically. There is evidence of close correlation, but not enough solid informationto affirm there is direct causality. 69 The final observation flows from the third. The analysis has in the process of assessing ZE costs and benefits revealed a quite disturbing degree of inequality across Chile's regions. At the very least these inequalities merit first call on any new regional policy initiatives. 6.17 The final part of the study focused on the rethinking and reworking of Chile's policy toward the Zonas Extremas. The first concern has to do with the possible pressures for either maintaining or -even more concerning-expanding current ZE policies. Because the ZE policies are more in the nature o f a collection of instruments than integration among instruments, and because the ZE likewise comprise a selection of regions, provinces, and comunas rather than a set of defining criteria, both instruments and the areas that come under the umbrella of the ZEs will be under pressure to expand. Like the province of Tocopilla in Region I1 becoming a recent addition to the ZEs. And in terms of instruments, the introduction of Ley Arica in 1995 and its reworking in 2001 reflect the system's vulnerability to political and interest group pressure. 6.18 Relatedly, the fact that the geographical, demographic, economic and social characteristics of the north and south of Chile vary considerably, the existing complement of ZE policies do not appear to be adequate for targeting the specific needs and opportunities facing the separate ZE regions. 6.19 For all of these regions the study needs to rethink and rework the entire range of ZE policies and approaches with an eye to makingthem more efficient not only in their own right but ensuring as well that they resonate collectively with the challenges and opportunities facing 21st century Chile. Accordingly, the report approaches the policy implications and policy options aspects by focusing on two alternative sets of policy options that progressively embody more ambitious and forward-looking approaches. First, the report sketches a second policy cluster directed toward implementing a targeted approach to developing the North and the South in a diflerentiated way by incorporating their respective, and significantly different, growth potentials into instrument design. This will serve to convert the static and defensive Zonas Extremas into a more aggressive, anti-poverty-focused and growth-oriented zonas estratkgicas policy. The ultimate aim must be to overcome the static concept of "extreme zones" infavor of a more dynamic perception of "strategic zones" or "strategic regions". 6.20 Second, the report addresses a group of options that take Chile beyond Zonas Extremas to embrace the vision of a need for, and avenues toward, a more coherent and dynamic regional policy for the whole of Chile, not just for the currently designated ZE regions. This would require more fundamental reform o f the present institutional setting for policy making and governance sector with the aim of strengthening local public decision- making and accountability. It would also require a more comprehensive view of a human capital based, and growth- and export-oriented regional policy in Chile. 70 ANNEXES A. STATISTICAL ANNEX48 Table A.l Poverty I cidence 32.7 27.1 25.3 25.2 24.7 19.2 20.6 Source: WE. Table A.2 (Monthly HouseholdAutonomous Average Income) (Pel November VI1 312.817 IX X 323.626 VI VI 335.441 Ill IV 345.291 IV Vlll 363.801 VII Vlll V XI Ill 486.030 I II II 546.184 RM RM 623.674 Total 471.418 Total Source: WE. 48 World Bank Estimates based on INE 71 Table A.3 CompetitivenessIndex 2002, based inthe Index Methodologydevelopedjointly by the UNDP !A.4 RegionalDens Y Region Inhab/Km2 Metropolitan 394.9 Valparaiso 93.9 Bio Bio 50.4 O'Higgins 47.8 Maule 29.9 Araucania 27.3 Los Lagos 16.0 Coquimbo 14.8 Tarapac6 7.3 Antofagasta 3.9 Atacama 3.4 Magallanes AysCn TOTAL COUNTRY 20.0 Source: WE. 72 Table AS RegionalPopulations,2002 Census,in '000 POBL :ION REGIONP (Censc .002- MilesHat ~ 3 OW 0 Source: INE. Table A.6 Populationof Most Important Cities within ZEs Remainder Coihaique of Region 49% XI 51% Punta Arenas Remainder 88% of Region I Arica and lquique 91% Source: INE. 73 B. REGIONXI AYSEN Degree of decentralization 1. A cluster of questions was posed inthe concept note about the present andprospective degrees o f decentralization in Chile and the connection with these issues with regional development and poverty. 2. It is evident that regional and local authorities were completely dependent, and mildly resentful, about the hegemony of Santiago in decisions affecting the regions. Inthe words of one member of a discussion group, government was a matter o f "Lagos para abajo", meaning policy on local affairs i s decided by the President o f the country and transmitted downwards, as if no consultations was sought nor needed at the local level. Of course, the question of elections goes well beyond the issue of whether elected leadership i s more effective in developing local andregional economy. 3. It is useful to note that the field visits covered informants who represented both strong leadership from outside the region and weak leadership from native sons. But it is undeniable, as a principle of governance, that the issue of elections turns on whether selection o f leaders b y popular (or indirect) vote would improve accountability and legitimacy of government. Though elections might produce weaker local leaders with less capacity to mount and sustain a development campaign, this should also not be a reason to continue further with decentralization that would include greater degrees of accountability to residents and taxpayers. 4. At the same time, it is hardto imagine that elected regional governments would not be more effective in speaking for regional interests and leading. Many lessons from L A C and elsewhere (Venezuela, Brazil, Mexico, Ireland, Scotland) indicate that local economic development i s not necessarily the most important issue and not always the comparative advantage of elected officials. Elected leadership can strengthen the internal dynamic and buy-in from voter taxpayers, and elected leaders might be able to mobilize stakeholders. But experience also shows that elected local governments are as likely as not to use regional planning as a way to justify favorite projects. 5. The issue i s not merely shifting to electoral choice, but perhaps, elections and moving towards a different balance o f fiscal federalism inwhich electoral and political accountability, important for legitimacy in its own right, can be blended with effective interventions from central government. What responsibilitiesand key servicesshould such a regional government have 6. Both regional Intendentes the team interviewed demonstrated a proclivity for key functions of regional government: to identify and pursue a developmental pathway that fits local circumstances and needs. The Intendente in Los Lagos spoke of consolidation and long- term development. A cogent set of principles was also visible in AysCn, but it was much less 74 clear whether and how the government in AysCn would carry a program forward. Schisms were close to the surface among various stakeholders in AysCn -private sector, bureaucrats inpublic administration, and the Intendente himself-about the vision and way forward. 7. Furthermore, a vision forward i s only the first step. Regional governments like Los Lagos, and AysCn more perhaps than others, should be able to elaborate more detailed, multi year development plans. They are at presented frustrated. "We (in AysCn) have trouble getting and audience and being heard." Various members of the chamber of commerce spoke of spending 150hours in conference and task teams to arrive at common vision and statement and got "no echo" from the centre. They cited Magallanes and Concepci6n as regions where vision and plan are very clear on the part of the public and private sector. Provinces should have the authority, but AysCn would need more assistance, to develop convincing provincial plans in concert with local stakeholders and the international financial and investment interests (e.g., ineco-tourism, sports fishing, mining). 8. Promotional efforts that excite the participation and support of civil society and the private sector can be partly shared by local governments and civil society, but here higher degrees of outside professional help become more important. In regions with more opportunity and less acute challenges in infrastructure and resources, leadership, planning, and promotional efforts, can be found in many places. In AysCn, and a lesser extent, Los Lagos, local leadership and efforts of a dedicated CEO and professional skill are needed to mobilize, follow through and consolidate actions. More effort i s needed to connect local initiatives with support from the centre for long-term investment and development. These implementation aspects of regional growth are not so evident in national policy, which i s expressed, and largely left, in lofty terms, and measured in quantitative data that do not capture the sustained effort needed on the ground and in the centres of power (see section on EUandlaggingregions). 9. Local governments also want and would benefit from having more autonomy in finance and decision making about provincial public goods. Regional initiatives are being taken now (Palena and Magallanes) to align various investment programs of sectors with regional priorities. AysCn also has held many public and private meetings around a plan and vision, but the effort seems to have dissipated over time. Some informants spoke of wanting to focus efforts on few key projects and fit together with others from central ministries. 10. Another issue involving high transaction costs for local and national public sector alike i s the need to work on annual basis for programming and construction of public works. The process of regional funding i s long, and the shortened seasonal cycle in AysCn eats up a good fraction of the year, meaning project implementation and disbursement have to be telescoped into the last quarter of the year. Longer budgetary cycles (multi year budgeting for the regions) or more access to regional funds (or national funds for regional development on a competitive basis) might help. 11. Marketing, promotion and advocacy. The two regions are also at very different stages inlocal identity and in marketing and promotion of their comparative advantage. ChiloC and Magallanes are well known for distinct cultural orientation, a strong sense identity and way of life, and in Magallanes, a proactive posture in pursing its agenda. These cultural features no 75 doubt help the regions; it i s another matter to create them from scratch. Incentive for private sector to invest inisolated regions 12. AysCn offers a special combination of primary and agricultural resources, coupled with potential for sophisticated tourism. Available data seem to indicate that the present instruments make little or no difference in the motives for new firms to settle in AysCn. Why then do firms come? Natural resources, including salmon, timber, mining, sports fishing, tourism and livestock, are the key reasons. Some cost savings help attract them, especially those in comparison to competing regions. But base cost i s only one factor. One Spanish investor asked first about assurances that the environmental quality for rivers will be maintained over long term. When he learned that this was beyond the control of the province, he turned away without further interest. 13. Both regional governments reflected an understanding that more needs to be done in public private cooperation and planning, and one (AysCn) spoke convincingly about the lack of direct experience to bring in private sector. The feeling i s somewhat frontier like institutional arrangements with a growing understanding that in the past decade, new sectors are taking off and that the institutional culture i s not prepared for the specific characteristics of these sectors (foreign capital, services oriented, multi-faceted coordination). The Governor of ChiloC knows that TA i s needed in key areas (sports fishing, tourism), but has no direct access to this assistance. 14. An anecdote told to us at the chamber of commerce illustrates these gaps. A Japanese businessman, eager to invest in fisheries outside of the high competition area in Los Lagos, sought information with local governments. Other towns in Los Lagos rolled out the red carpet. But the businessman was frustrated in his repeated attempts to see public authorities in AysCn to obtain basic information. Only by accident did he run into someone at the Chamber who was able at least to keep the investor from dropping his plans. Can regions create an enable environment and what does this imply for role of regional governmentsand instruments for growth? 15. Both provinces spoke in terms of the bureaucracy (Provincial and national, e.g., tax administration) in slowing down and making process either more difficult, weakening the incentives, or neutralizingtheir impact. 16. Capacity building and new institutions are also needed to develop and manage regional development, for instance, through corporations (such as that in Bio Bio) designed for this purpose. Furthermore, in AysCn, there are no supporting institutions in the secondary tier, like full time university staff, research stations, or agricultural extension facilities, much less think tanks and policy advisory services, near by to help in day to day analysis to whom public and private sectors can turn for help. 76 Interregional arrangements and Horizontal Cooperation. Inwhat areas should regional andmunicipal governments collaborate? 17. Local governments can continue to provide basic infrastructure and poverty alleviation measures, in coordination with regions and municipalities. It would be hard to imagine, and probably counterproductive, to think about changing the national system for poverty alleviation. Rather, emphasis should be placed on bringing smaller municipalities in AysCn and Lagos up to national standards indistribution. 18. ZEs can be in position to formulate vision and possibly to agree priorities; they are further away from being able to focus on specific, long term investments to complement or fill incentral government programs. Aisen has launched an environmental capability planthat appears to lay the groundwork for more rational use of natural resources. This should be encouraged and buttressed with national effort to enforce the plan. 19. Local governments could also work together to exchange ideas and information, reach common policies, and achieve economies of scale injoint efforts to lobby national agencies and achieve higher fidelity voice in national government. Governmental and private organizations could well benefit also from observing the practice and policies of regionalism in OECD countries and elsewhere, for instance, in Mexico, Northeast Brazil, Irish and Scottish development strategy and agencies, Italy's micro-regional pacts for development, and Spain's autonomous regions. Role of market incoordinate priorities across levels of government 20. A possible risk of market distortion is created by the kinds of incentives currently in place. Only very large, and currently profit making firms are liable to be influenced by the instruments. Also, in Palena, small firms need more help in taking advantage of the incentives open to them. As for public private coordination, there is no "mesa de concertucidn" and culture of coordination and joint planning i s not yet in place in AysCn. A factor that makes cooperation more difficult i s that the sectors are heterogeneous in nature. Cattle ranchers are small and disorganized. Tourism more organized and meets regularly. Salmon factories operate "independently" on their own without much consultation. Forestry and agriculture i s somewhere in between inthis spectrum of organized and articulate. Supplementary Research Agenda 21. This study can only begin to identify in which manner, to what extent, and at what cost the drivers of change identified in the main text have affected the context, the impact and the efficiency of ZE policies. 77 c. CAPITAL VS. EMPLOYMENT SUBSID9' 22. Considerable caution needs to be exercised in deciding whether to favor capital or employment subsidies. The effect of employment subsidies i s more complex than indicatedby static production function analysis. The employment effects will vary from firm to firm and from industry to industry. Furthermore, practitioners have persuasively argued that while there may be a theoretical case for wage subsidies, they are far more difficult to administer than investment grants. However, in a period of severe unemployment, labor subsidies appear to have advantages over investment grants, given that the main objective i s to create employment inlagging regions. 23. There are advantages and disadvantages associated with the various types of financial incentives (see Table A.7). Each incentive can be applied in many different ways and the disadvantages can be minimized by carefully designing the way they are used. D. INTERNATIONAL EXPERIENCES: ENTERPRISE ANDEXPORT ZONES PROCESSING ZONES" EnterpriseZones 24. Enterprise Zone (EZ) policy was originally developed with the aim of generating inward investment to overcome market failures in tightly targeted distressed areas. These types of initiatives have been in existence in the UK and the United States since the early 1980s. A number of further special zone initiatives have been introduced more recently, including the Zones Franches Urbaines in France and the Area Contracts in Italy (Potter and Moore 2000). The common feature of EZs i s the availability o f tax subsidies and other benefits in specially designated localities. The EZ approach i s now active in other European countries (Ireland, Netherlands, Hungary,Poland and Russia) and elsewhere (Israel, Australia, China, Japan, Philippines and Vietnam). 25. EZ policy instruments in the UK have included exemptions of property from local business rates, enhanced capital allowances against tax liabilities for investment in property, a simplified planning regime and a reduction in requirements to respond to government statistical inquiries (Potter and Moore 2000). These incentives are only available within the EZ and designation is limited to 10 years. In most cases, incentives are accompanied by significant public spending on infrastructure within the designated areas. Initially, EZs were focused on distressed urban areas where the contraction and relocation of existing industry, combined with failure to attract new investment, had resulted in a high concentration of economic and social problems. More recently, the approach has been concentrated in areas experiencing severe decline o f basic industries. 49World Bank, 2002. Regional Development Policies, Theory and a Review of the Evidence, Maranhao, Brazil. World Bank, 2002. Regional Development Policies. Theory and a Review of the Evidence, Maranhao, Brazil 78 Table A.7. Advantages andDisadvantagesof the Various Incentives Incentive Advantages Disadvantages Investment or Simple and explicit; benefits can be calculated easily and D Expensive. capital grants . quickly and have a direct bearing on the decision where to Bias toward capital-intensive place new investments. projects. Highly flexible and can be made available on a full or partial, Spread effects inthe form of automatic or discretionary basis. inflationary pressure on other Practical for covering extra costs involved in a new regions. establishment and circumvent the criticism o f encouraging long-term inefficiency. Facilitate financing of project, which may be important for smalland medium-sized firms and for encouraging investment inlagging regions. Encourages new investment in building, plant and machinery. "Soft" or subsidized Projects are financially evaluated by a private or public Not particularly transparent. loans5` institution. Benefits may not be so easy or I t i s not necessary to mobilize large amount of capital at the quick to evaluate. outset. Expensive. Bias toward capital-intensive projects. Spread effects in the form of inflationary pressure on other regions. Tax concessions and Benefits favor efficient investment. Concept not easily understood. accelerated Subsidy depends on firm's viability and thus avoids waste o f Allowances are part of national tax depreciation public funds. system and may have limited allowance potential inregional policy. Applies only when firm i s profitable. Employment Bias towards labor-intensive projects. Can be costly. subsidies Implies no discrimination against existing firms. Complex output and substitution Minimize spreading effects to other regions. effects of capital and labor need to Incorporates an income transfer from rich to poor regions. be considered indecision-making. Effects not always obvious, Le. may not result in increased employment. Rather may be reflected in increasedwages or increased profits. Large inefficiencies due to non- additionality and deadweight spending. Administrative Administratively cheap. Prone to corruption. controls Flexible; allows consideration on a case by case basis and May discourage investment. varying stringency with economic cycle. Creates a direct relationship between regional policy and physical planning policy. Source: Vanhove and K asen (1987). 51 Soft loans are in fact closely related to capital grants and it i s fairly easy to calculate their grant equivalent. Soft or subsidized loans may be offered directly by the state or by financial intermediaries with the state as the benefactor or the guarantor. Loans are "softened" by reducing interest rates or delaying repayment of principal. Insome countries, investors have achoice between a grant and interest rebates. 79 26. Unlike the UK, EZs in the U S were initiated by the states rather than by the Federal government. Given that they were initiated by the states independently, the programs varied considerably in the type and monetary incentives offered the criteria for selecting the targeted areas, and the eligibility rules. The US programs also differed considerably from the UK, in that they were more community-focused, rather than merely stimulating dormant industrial areas. 27. From the onset o f the program inthe UK, inward investment was viewed as one of the principal means for creating jobs in areas with severe economic problems. There were serious doubts, however, about the extent to which EZs would be successful in stimulating local regeneration through inward investment. First, there were questions about the ability of the policy instruments to attract investors into the zones. Second, there were concerns about the quality o f investments attracted - in terms of employment opportunities and linkages with local economies. Third, it was feared that the policy would merely attract local relocations of firms rather than new investmentinto the locality. Export ProcessingZones 28. When measured against these broader economic and social objectives, the results of zone strategy are mixed. The host country spends large amounts of money on the infrastructure, maintenance and operating costs of the zones and may well have to upgrade the facilities at a later stage. In addition, there i s also the added opportunity cost of foregone earnings from taxes and duties and the diversion of resources from other development activities. These costs will need to be balanced with the benefits generated by the zones. 29. Backward linkages, if they could be created, would certainly help to generate more indirect employment. Inmost countries, they are still insignificant. According to an ILO study (1996), the value of local inputs in virtually all Export Processing Zones (EPZs) host countries rarely exceeds 2.5 percent o f total imports. Two outstanding exceptions are Mauritius, where local suppliers provide 30 percent or more of inputs for the textile and garment industries, and the Republic of Korea where producers of electronics goods buy at least 50 percent of their components on the local market. The industry that accounts for the highest percentage of local sourcing i s the food processing industry. InMexico, for instance, about 43 percent of the food processing industry'sinputs come from domestic suppliers. E. CONSTITUTIONAL ANDLEGISLATIVE INITIATIVES THAT MIGHT CHANGETHE SCOPEAND PURPOSESOF REGIONAL GOVERNMENTSAND REGIONAL DEVELOPMENTPOLICIES. 3 o . There are a number of Executive initiatives regarding decentralization currently before Congress. These initiatives include, inter alia, the following: 1. Laws approved to create four comunas: Alto Hospicio (Law 19.4943 of 22/04/04), Hualpencillo (Law 19.936 of 13/03/04), CholChol (Law 19.944 of 22/04/04) and Alto Bio Bio (Law 19.959 of 21/07/04). 2. Law approved about "Gambling Casinos" 3. Law proposalto reform Municipal Revenues (RentasMunicipales 2) 80 4. Law proposal that reforms the Constitutional Organic Law about Regional Government and Administration (LOCGAR) 5. Constitutional Reform proposal about Regional Government and Administration 31. The first two initiatives listed above appear to respond primarily to individual political demands. The Ley de Rentas Municipales 2 has been in Congress for the past two years. Its stated objective i s to increase municipal revenues; however, it does not include instruments that radically modify the municipal financing system. Initiatives 4 and 5 above could produce an important reform on regions and regional development policies. 32. The next two tables include a synthesis of the two latter initiatives: TableA.8 Synthesisof proposedreformsto the ConstitutionalOrganicLaw about Regional Government andAdministration(LOCGAR) Issues Proposed reforms Responsibilities and 0 Responsibilities and attributions of Regional Governments are expanded attributions of the Regional The Intendente will have the attribution to coordinate regional public Government services Strengthening Management Creation of Regional Manager (Administrador) position I Capacity and accountability at Regional Governments are required to maintain and publishtheir Cuenta the Regional Level Pliblica similar to the national government. 0 Higher remunerations/compensationsto Regional Advisors Regional financing and Investmentby central agencies in the regions will be considered part of budgeting regional government investment The ministries shall informregional governments about their investments inthe regions FNDRprograms will not only pursue Territorial Compensation but Regional Development as well The scope of programming agreements will be expanded to allow agreementsbetween any public or private entity and national, regional or local governments RegionalAssociation Regional governments can get together for the creation of corporations 0: foundations for regional development ource: Message No. 361-348 (January:i, 2003). 33. In is worth underlying the contents of the proposed LOCGAR in terms of decentralization, regional governance and regional development policies: 0 Higher coordination and complementarity between national sector ministries and regional authorities for purposes o f investment programs 0 Higher flexibility for regional Programming Agreements, inter-region associations and public -private partnerships at the regional level 0 New emphasis on regional development. The criteria for regional distribution of FNDRfunds will be amended to reflect this new priority 81 TableA.9 Synthesisof proposedConstitutionalreformsonRegionalGovernmentand Administration Area ProposedReforms Increased o f regions in the The reform will allow the creation and elimination of regions by laws countrv (higher vote requirements) Strengthening Management Government can issue special decrees for strengthening government Capacity of Insular Territories and management of insular territories of Easter and Juan Fernandez and MetropolitanZones Islands. The law may establish a special administration for "Metropolitan Zones" The Intendente Intendentes Will have the ruling power to dictate norms for the implementation of laws in the region. Will coordinate public services inthe region. The President can delegate to the region the direct administration of national or sector competencies. Direct elections for Regional Regional council members will be elected by universal suffrage. Programming Agreements could be signed between municipalities and between them and the regions. Source: Message No. 47-350 (December ,2003). 34. The proposed constitutional reform would significantly increase the participation and management capacity of the regions for formulation and implementation of regional development policies: 0 It would allow the drawing and redrawing of regional territories in correspondence with the dynamics of regional economies and social demands. 0 It would also allow special regimes for insular territories and metropolitan areas, thereby allowing further flexibility of the legal framework in correspondence with special territorial needs. 0 It would expand the capacity of the intendentes for Inter.-government coordination of programs and projects intheir territories. 0 It would establish the regional representation of council members, thereby further consolidating the region as a semi-autonomous level of government within a unitary state. 0 It would consolidate the enlarged scope of Programming Agreements that is already included inthe LOCGAR. 82 F. WORKPROCEDURES,OFFICIALSMET, BANKTEAM AND 35. From May 19-23,2003 at the request of the Chilean Government, the team went on an identification mission to Santiago to meet with various authorities in Chile to introduce the World Bank team to the government to evaluate the fiscal incentives currently in place for Zonas Extremas, to hold meetings with both governments (national, regional, provincial, local) and private sector stakeholders and to begin discussing with various government entities the benefits of these incentives. The mission was coordinated by the Ministry of Finance (Direction of Budget) which was the government main counterpart for the study. 36. Duringthe 2ndmission (September 1-4, 2003) the team: i)finalized data collection; ii) further discussed hypothesis among team members and ensured full cohesiveness and balance of the draft report; iii)prepared a third version of the report, and iv) discussed main findings, analytical framework and recommendations with the Chilean authorities. A workshop took place to this effect for Thursday, the 4th of September. 37. The presentation of the Study to the Chilean authorities took place on January 4-9, 2004 in Santiago, the mission met with a delegation of the Regions, the core team of the Ministry of Finance and a number of representatives of key ministries involved in the Extreme Zones Policies and with various Directorates individually, to open the discussion on the findings of the study and to receive comments and suggestions for the presentation to the Minister of Finance at the end of the mission. Name Title Organization I I Santiago Mayo 19-21,2003 Claudio Jukez Advisor Ministry of Finance and Member of the Board of ZOFRI (Zona Frunca de Zquique) AndrBs Zahler Advisor Ministry of Finance MichelJorrat Internal Revenue Service (SII) Ministry of Finance Julio Ruiz Head of the Regional Development Direction of Ministry of the Interior the Deputy Secretariat of Regional Development, SUBDERE. Samuel Garrido Head of the Municipalities Division Ministry of the Interior LuisAngulo Advisor for Regional Policy of the Ministry, Ministry of the Interior responsible for developing a proposal for special territories. Maria Inks Rousse President of the Inter-ministerial Committee for Ministryof the Interior ZE and Special Territories Policies (CIDEZE) (SUBDERE) Dario Cabezas Member of the Inter-ministerial Committee for ZE Ministry of the Interior and Special Territories Policies (CIDEZE) (SUBDERE) Joaquin Vial Former Budget Director, Ministry of Finance Columbia University (The EarthInstitute, Andean Competitiveness Project) Pilar Camper0 Policy Division for Competitiveness Index Ministry of the Interior (SUBDERE) Raul Acevedo Territorial Statistics Instituto Nacional de Estadistica (INE) Name Title Organization I r LuisHidalgo Regional Studies (SUBDERE) Ministry of the Interior Sergio Galilea National Director for Highway Administration Ministry of Public Works Claudia Serrano Expert in decentralization and regional funds. Corporacidn de Fondo Nacional de Desarrollo Regional (FNDR) Investigaciones Econdmicas para Latinoame'rica - CIEPLAN- Mario Castillo IZonas Extremas and Special Territories Program IICorporacidn de Fomento de la I Region Wenceslao Unanue I Regi6n ISEREMIFinance I Ministry of Finance 84 Hector Canales President Multigremial Council Marcelo Maldonado General Manager Salmones Antdrtica Eduardo Santelices General Manager AJECO Distribution Cesar Moncada General Secretary Small industries Association Sergio Marin President Chilean Construction Chamber Ren6 Villegas General Secretary Chilean Construction Chamber 1Ministry of the Interior MichelJorrat Internal Revenue Service (SII) Mario Marcel, Maria Core team that discussed the study with the Bank Ministry of Finance EugeniaWagner, on a first presentation. Catalina Bau, Marcelo Tokman, Claudio Juarez and Andres Zahler I ~~ Source: World Bank Staff. 85 Table A.10 Team CompositionandMissionSchedule lSt IdentificationMission (May 19-23,2003) Ignacio IrarrAzaval iirarrazaval@Focus.Cl Enrique Fanta efanta@Vtr.Net Paul Bernard Spahn pbspahn@wiwimi-frankfurt.de Remy Prud'homme prudhomme@univ-paris12.fr Azul del Villar adelvillar@worldbank.org PatriciaMendez Dmendez@worldbank.org Fernando Rojas frojas@worldbank.org DanielFernando Oks* doks@worldbank.org Wolfgang Koehling wkoehling@worldbank.org PatriciaMendez pmendez@worldbank.org 52 Separate identification mission to Regions X and XI on June 8-9,2003. 53 Participated in a Seminar with Parliamentariansand Government authorities about Free Trade Zones in Santiago in June, 2003. * Joinedthe mission for severalmeetings. 86 BIBLIOGRAPHY Artana D. andLopez Murphy R. "Descentralizaci6n Fiscal: Algunas Lecciones para AmCrica Latina" Working Document 42, October 1994 Breen, Richard andBrendanHalpin. 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Guimaraes, P., R. J. Rolfe andD.Woodward. "Regional Incentives and IndustrialLocationin Puerto Rico." International Regional Science Review 21 (2): 119-38, 1996. InformeRegional de Competitividad, SUBDERE, Ministry of Interior, 2002 Instituto Nacional de Estadistica, INE, "Evoluci6n Econ6mica de TarapacB" Direcci6n Regional de Tarapacd, Chile 2003. International Labor Organization (LO). Export Processing Zones: TheSocial and Labor Issues. Paper preparedfor the African Regional Workshop on the Protection of Workers' Rights andWorking Conditions inEPZs and the Promotion of the Tripartite Declaration of Principles Concerning MultinationalEnterprises and Social Policy. Johannesburg,July 1996. JICA, Ministry of Economy, Development and Reconstruction andCORFO "Study for Promotion of Investments andExports for the balanced Economic Development inthe Republic of Chile" Volume 1, Analysis and Volume 2, Strategy andAction Plans. October 2001. Journal of Regional Policy. Special Issue. Vol. 12. 1992. Matis Perez L."Responsabilidad, Gesti6n y Control que ejerce el Servicio de Tesoreria en 10s Beneficios que entrega el supremo Gobierno para las Zonas Extremas (Region I)" Chilean Treasury. 87 Ministry of Finance, Chile "Terms of Reference for Assessing and ReformulatingZE Policies" January 2003. Organisation for Economic Co-operation and Development (OECD). Marginal Employment Subsidies. Paris: OECD, 1982 Pasha, H.A. and K. Bengali. "Impact of Fiscal Incentives on IndustrializationinBackward Areas: A Case Study of Hub Chowki inBaluchistan." Pakistan Journal of Applied Economics 4 (1):l-16, 1985. Picard, P. M. "Job Additionality and Deadweight Spending inPerfectly Competitive Industries: The Case for Optimal Employment Subsidies." Journal of Public Economics 79: 521-541,2001. Potter, J. and B.Moore. "UK Enterprise Zones and the Attraction of Inward Investment." Urban Studies. 37(8): 1279-1312,2000. Raczynski D. and Serrano C. Editors "Descentralizacih. Nudos Criticos" Corporacih de Investigaciones Econ6micas para LatinoamCrica. CIEPLAN. Chile, September 2001. Regional and Administrative Development Deputy Secretariat, Ministry of the Interior "Financiamiento Municipal" July 2001. The World Bank. "Brazil, Maranhao State Economic Memorandum", Regional Development Policies. Theory and a Review of the Evidence. June 27, 2002 SEREMIde Economia "Leyes de Excepcidnen la XI1Regi6n" Chile, May 2003. Sinn, H.W.;Flaig, G.; Werding, M.;Munz, S.; Dull,N.;Hofmann, H.,EU-Erweiterung und Arbeitskraftemigrati0n:Wege zu einer schrittweisenAnniiherung der Arbeitsmilrkte,Munich 2001 Soluciones Integrales S.A., "Zonas Francas" Economic Analisis of the Free Trade Zones System inChile, March 2000. Sprenger, R. "Inter-Firm Networks and Regional Networks" ADAPT of the FederalLabor Office in Bonn, Germany. 2001. Universidad de Chile, "Desregulacibn de las Actividades Econ6micas en las Regiones Extremas" Magallanes Region, Chile, April 1996 Unutia & CIA, Abogados "Informe para la Subsecretaria de Desarrollo Regional y Administrativo, SUBDERE", Chile, May 2001. Van der Linden. Effet de perte skche et de substitution des formations professionnelles et `I des aides B l'embauche", Bulletin de l'IRES, IRES UCL, 1995. Vanhove, N. and L.H.Klaasen. Regional Policy: A European Approach (second edition). Aldershot: Grower PublishingCompany Limited, 1987. 88 Wren, C. "Build-Up and Duration of Subsidy-Induced Employment: Evidence from U.K. Regional Policy." Journal of Regional Science 34: 387-410, 1994. "Subsidies for Job Creation: I s Small Best?" Small Business Economics v. 10, no. 3, May: 273-81, 1998. .UKRegional Policy :Does it Measure Up? Department of Economics, University o f Newcastle, 2002. Websites: Economic Commission for Latin America and the Caribbean: http://www.eclac.cl Instituto National de Estatistica: http://www.ine.cl Ministerio del Interior, SUBDERE: httu://www.subdere.cl/paginas/cedoc/publicaciones/comuetitividad/publi11.html Ministerio de Hacienda, DIPRES: http://www.dipres.cl 89 IBRD 33386 85°W 80°W 75°W PERU To 70°W To 65°W 60°W La Paz Tacna To Corque Arica Attacam A 1 nde BOLIVIA To Iquique as Uyuni Dese M 20°S Tocopilla tr CHILE Calama 2 Antofagasta ountains PARAGUAY To Salta To Tolar Grande 25°S 25°S To Fiambalá Copiapo 3 Nevado Ojos del Salado Vallenar (6,880 m) PACIFIC OCEAN La Serena To Ovalle 4 Rodeo 30°S 30°S REGIONS OF CHILE 5 To Villa Nueva 1. ARAPACÁ Valparaíso SANTIAGO 2. ANTOFAGASTA 6 3. ATACAMA 7 Rancagua URUGUAY 4. COQUIMBO 5. VALPARAÍSO Talca 8 ARGENTINA To 35°S 35°S 6. REGIÓN METROPOLITANA Bardas Blancas DE SANTIAGO Concepcíon Chillán Chillán 7. LIBERTADOR GEN. 9 BERNADO O'HIGGINS To Victoria Las Lajas 8. MAULE Temuco 10 9. BÍO-BÍO 10. ARAUCANÍA To 11. LOS LAGOS Osorno Nahuel Huapí 12. AISÉN DEL GEN. CARLOS 40°S 40°S Puerto Montt IBÁÑEZ DEL CAMPO 13. MAGALLANES Y ANTÁRTICA 11 CHILENA Puerto Quellión Quellión ATLANTIC This map was produced by the Map Design Unit of The World Bank. ountains OCEAN The boundaries, colors, denominations and any other information shown on this map do not imply, on the part of The World Bank Puerto Aisén Aisén M Group, any judgment on the legal status of any territory, or any To endorsement or acceptance of such boundaries. Coihaique 12 des Paso Río Mayo 45°S nA CHILE Puerto Yungay 0 200 400 600 Kilometers SELECTED CITIES AND TOWNS 0 200 400 Miles REGION CAPITALS NATIONAL CAPITAL 13 To Río Gallegos 50°S RIVERS Strait of Manatiales Magellan MAIN ROADS Punta To FALKLAND ISLANDS (ISLAS MALVINAS) Arenas San Sebastián A DISPUTE CONCERNING SOVEREIGNTY OVER THE RAILROADS ISLANDS EXISTS BETWEEN ARGENTINA WHICH CLAIMS THIS SOVEREIGNTY AND THE U.K. WHICH ADMINISTERS THE ISLANDS. REGION BOUNDARIES INTERNATIONAL BOUNDARIES Cape Horn 80°W 75°W 70°W 65°W 60°W 55°W 50°W SEPTEMBER 2004