Freeports and Investment Zones – what sorts of things should we consider when assessing whether they are good policy?

The IFS has today published a report on the government’s flagship Freeports programme, which will provide tax and customs incentives and a range of other support in, eventually, around 12 locations across the UK.

At the heart of the report is a discussion of the economic issues central to whether Freeports and related policies – such as the Investment Zones that we may hear more about in Wednesday’s Budget – are a good idea. As we explain below, the extent to which activity in Freeports is genuinely additional, as opposed to something that would have happened in the UK anyway, is a key consideration – but far from the only one.

A location-specific, time-limited package of tax incentives and other support

The core of the Freeports programme is the location-specific and time-limited tax incentives and other benefits that it provides. All else equal, such policy variation across locations and times would be undesirable. It distorts the location and timing of economic activity so that, rather than taking place where and when it is most economically efficient, it takes place where and when it is most tax-advantaged. Moreover, because the losses from the disincentive effects of taxation rise more than proportionally with the tax rate, having some areas (and times) with higher taxes and others with lower taxes entails a higher economic cost than having the same rate apply everywhere.

The economic case for the Freeports programme and similar policies is that all else may not be equal. One could have concerns about inequalities between different parts of the country, and the impacts these have on the people living in them: even an efficiently functioning market is no guarantee of fairness. Tax incentives and other support could then be used to help with ‘levelling up’. Indeed, this is a central aim of the Freeports programme, with several of the Freeports located in some of the most deprived towns and cities in England.

However, if one’s primary concern is people’s material living standards, using the tax and benefit system to redistribute income to poorer households can sometimes be a better approach than trying to influence where economic activity takes place. Perhaps even more important to the economic case for Freeports, therefore, is that markets, on their own, may often not lead to an efficient level and distribution of economic activity. These ‘market failures’ provide a rationale for government intervention to help overcome them. 

The role of agglomeration effects

In the context of the Freeports, a key example is agglomeration effects. This is the idea that there can be benefits to certain kinds of businesses from being near to certain other businesses (or research centres), allowing more interchange of specialised people and ideas and making shared resources and infrastructure more cost-effective. While such clusters can form spontaneously, it can be hard for businesses to co-ordinate on achieving this outcome, and each may not take into account the benefit they bring to others. In that case there can be a role for government in catalysing such clusters by, for example, providing tax and other incentives for businesses to locate in a particular place. Agglomeration effects could make the clusters generated self-sustaining after the expiry of the incentives, and make such geographically targeted incentives more effective and better value than smaller incentives available nationwide.

Well-known examples of successful agglomerations include Silicon Valley (for IT and related industries), Hollywood (for film and TV production), and the City of London and Canary Wharf (for financial and professional services). The hope is that Freeports can create successful agglomerations for other types of industries – such as green technologies and high-tech manufacturing. Successes of this kind are rare and somewhat unpredictable – though the payoff from success can sometimes be large.

The government and Freeports are doing various things to increase the likelihood of successful agglomerations developing. Freeports have, for example, been asked to identify the sectors that they will target, and demonstrate how the tax incentives and other support provided could help to overcome coordination problems and other market failures. They have also had to agree broad plans for land usage and put in place plans for complementary investment in infrastructure, skills and innovation, utilising funding being provided via the programme.

However, governments and active industrial policies, as well as markets, sometimes fail. A key risk is that the wrong locations and sectors may be chosen, and Freeports may not be successful in creating the clusters they hope for. In this context, too tight a focus on particular sectors could prevent other, potentially more viable, sectors from locating in the Freeports. This means there could be a tension between ensuring plans are sufficiently adaptable to respond to market signals and maintaining a focus on sectors associated with positive externalities and agglomeration effects.

Deadweight and displacement

Another risk is that, even if there is significant activity in the Freeports, a large part of it would have happened there even in the absence of the policy (‘deadweight’) or would have happened elsewhere in the UK (‘displacement’). Similarly, the people and capital employed in Freeports might otherwise have been employed elsewhere.

The government is trying to minimise deadweight and displacement in several ways. The areas within Freeports chosen to receive tax breaks were undeveloped or under-developed locations, and the tax breaks are only available for new employment and investment, not things already happening in the Freeport. Freeports are largely seeking to specialise in sectors that are not already operating at scale elsewhere in the UK, and, as noted above, were asked to show that there were viability gaps and market failures that meant that investment in those sectors would not go ahead without government support. In addition, the councils covering the Freeports can, if they want, apply a ‘displacement test’ to deny business rates relief to businesses relocating from elsewhere – although whether they will use these powers if a business is relocating from halfway across the country and central government is covering the cost of the relief is another matter.

Such measures should reduce deadweight and displacement to some – and possibly a significant – degree. However, they cannot fully mitigate this important risk. Displacement can take many forms. It is easier to observe, and prevent, existing businesses relocating to a Freeport than to ensure a new business in a Freeport does not come at the expense of businesses elsewhere, or that the people employed there would not otherwise have been employed elsewhere.

Of course, given the Freeport programme’s focus on regeneration and levelling up deprived places, displacement would not necessarily be a bad thing: a resulting reduction in geographical inequality could make it worthwhile, even if it comes at the expense of lower overall output.

Assessing whether Freeports are a good policy

The amount of additional investment and activity, both in absolute terms and relative to the amount of deadweight and displaced activity, will be an important determinant of whether the Freeports programme represents good value for money. If all of the activity were additional (which is highly unlikely), the tax incentives offered would not actually cost anything (you couldn’t have taxed activity that wouldn’t have happened), and overall revenues would actually increase as a result of impacts on other taxes (such as income tax and VAT) – although the capital funding and other support being provided to Freeports would still represent a cost. On the other hand, if all of the activity were displaced from elsewhere in the UK (also highly unlikely), you would need to place a much higher value on activity taking place in the Freeports relative to activity taking place elsewhere in order for the programme to be worthwhile.

But the extent of additionality, deadweight and displacement are not the only things that will matter. One needs to calculate the overall net effect of the policy on the government’s finances, as well as the financial and non-financial costs and benefits to households and businesses.

For example, if the Freeports boost the number of people in work, the tax paid on their earnings reduces the net cost of the policy to the government. The individuals themselves gain after-tax earnings but have less time for other things they may value (such as spending time with family). If the job/wage offer they obtain was only just enough to persuade them to work, the net benefit to them would be negligible – it is certainly not their entire net earnings from the job. On the other hand, if they would otherwise have been involuntarily unemployed, they might value the opportunity to work above and beyond the extra income they receive.

Exactly who is gaining and losing from the policy also matters, both for estimating impacts on the government’s finances (as tax rates vary across people and businesses), and for weighting the effects on different parts of the population (given that we may care more about benefits to lower-income people and places).

Determining all these different factors precisely would be an impossible task. In practice, some of them will have to be roughly approximated, or assumed to be negligible and so not worth trying to quantify. Together with the fundamentally difficult challenge of estimating the Freeports’ impact on key economic indicators, that means we will never have definitive estimates of the benefits and costs of the Freeports programme – and may be unable to say confidently whether or not the benefits exceed the costs.

However, as our report explains, the proposed evaluation does offer scope for learning about how the Freeports programme is being implemented in practice, and useful indicative evidence on the programme’s impacts on investment, employment and so on. This should help with the sharing of best practice between Freeports, and maximisation of the benefits of other similar policies, such as planned Investment Zones, in future.