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India's special economic zones policy, launched with a fanfare in 2005 to boost exports in Asia's third-largest economy, is in danger of fizzling out. With only 124 zones in operation, compared to the original target of 500, government officials are having doubts about the policy – and private sector investors building the zones are concerned about their financial viability.

Special economic zones (SEZs), benefiting from tax breaks for export-oriented activities, now account for 22 per cent of India’s total exports (worth $250bn in 2010-11). That compares with the 7 per cent of $100bn attributed to the handful of SEZs existing in 2006-07.

The increase is the SEZs’ share of exports is partly due to existing industrial complexes turning boosting exports and partly due to the creation of new export-oriented zones. The rules require that 70-80 per cent of production is exported compared to 25-30 per cent before 2005.

Infrastructure companies like Larsen & Toubro, the Tata group affiliate, is only one of a number of companies that are reported to be dropping out of the race to develop SEZs after their effectiveness came under fire from industry members and analysts. There are considerable doubts whether the policy can help achieve the government’s target of doubling India’s exports by to $500bn by 2014.

Sangeeta Prasad, CEO of Mahindra World City Developers, which has developed SEZs, told beyondbrics that investor sentiment was being dampened by a perception that the government was backtracking on promises of the valuable tax exemptions that are the main allure of an SEZ.

“The government promised us certain benefits and they’re being taken away from under our feet, why would we go in for it?” Prasad said. “…The direct tax code that’s been proposed will affect the sentiment of potential investors because they see their benefits being affected adversely.”

As part of its biggest tax reform in 50 years, India proposed last year to end the tax breaks ahead of schedule on profits that SEZ developers and participating companies enjoy, which cost the government $1bn in revenue in 2010 alone, the Economic Times reported.

Exemptions that were to last until 2016 began to be phased out from 2011. All new developers starting projects from March 2012 will face a 19.9 per cent tax on profits.

Red tape is also an issue. While in other countries, land and licence approvals for such projects take anywhere between three to six months, India’s legendary bureaucracy has slowed this process down to over a year in some cases, according to Punit Shah, partner at KPMG tax and regulatory services. At last count, three quarters of the planned SEZs remained in regulatory limbo.

“It’s the complex rules and regulations of the Indian bureaucracy that have played a major role in holding up [the development] of SEZs,” he said.

Unfortunately, that’s a familiar story for investors in India.