World Development Report 2024: The Middle-Income Trap

Key messages

• Economic growth in middle-income countries is different than that for countries at other income levels. Capital returns diminish at later development stages, and therefore countries, to achieve sustained growth, need to also focus on technological progress and improved efficiency in converting capital and labor into goods and services.

• Successful middle-income countries will have to engineer two successive transitions to develop economic structures that can eventually sustain high-income levels.

• The first transition is from a 1i strategy for accelerating investment to a 2i strategy focusing on both investment and infusion in which a country brings technologies from abroad and diffuses them domestically. Policy makers in lower-middle-income countries will need to add to investment strategies to infuse modern technologies and business practices from global leaders into their own economies.

• Once a country has succeeded in the first transition, the second transition is to switch to a 3i strategy, which entails paying more attention to innovation. Upper-middle-income countries that have mastered infusion can complement investment and infusion with innovation, thereby developing industrial structures and technical competencies to add value to and advance the global technology frontier.

Introduction

In Brazil in the early 1970s, after several decades of impressive output growth, the average worker in the manufacturing sector was more than 40 percent as productive as his American counterpart. By 2008, this ratio had fallen to 17 percent. Up until about 1980, Brazil implemented protectionist policies from foreign competition and provided incentives to substitute imports by domestic manufacturers. Although all these policies were intended to make Brazil more competitive, they led to a decline in the productivity of Brazilian workers, and enterprises became less competitive than those in the United States.

Meanwhile, in Northeast Asia something completely different was happening in the Republic of Korea and Taiwan, China. In the 1970s, the productivity of Korea’s manufacturing workers was less than one-tenth of their American counterparts. By 2008, their productivity was greater than 70 percent that of the average American worker in the same sector. Their enterprises became well known globally because their economies reinvented themselves after they had reached middle-income status—not once, but twice. Both economies grew rapidly to the upper-middle-income level, followed by the high-income level, and subsequently to levels of income and standards of living similar to those of advanced economies such as Germany, Japan, the United Kingdom, and the United States.

What changed between the 1950s and 1960s (when Brazil was a low-income country), the 1970s (when Brazil achieved rapid growth), and the 1980s and 1990s (when Brazil—and its neighbors such as Argentina and Colombia—became both a middle-income economy and an also-ran)? How did the trajectory of economic development differ in Korea and its neighbors Japan and Taiwan, China?

This chapter explores whether economic growth in middle-income countries is different than that at other income levels. The simple logic is that if it is different, then these countries’ development strategies cannot remain the same. The chapter points to evidence consistent with the hypothesis that successful middle-income countries have to engineer two successive transitions to develop economic structures that can eventually sustain high-income levels. The first is to transition from a 1i strategy for accelerating investment to a 2i strategy focusing on both investment and infusion in which a country brings technologies from abroad and diffuses them domestically (table 2.1). Policy makers in lower-middle-income countries will need to add to investment strategies to infuse modern technologies and business practices from global leaders into their own economies.

Once a country has succeeded in infusing global technologies and know-how in specific sectors or industries, it can switch to a 3i strategy by paying more attention to innovation. Upper-middle-income countries that have mastered infusion can complement investment and infusion with innovation, thereby developing industrial structures and technical competencies to add value to and advance the global technology frontier.

Infusion is powered mainly by technology transfers embodied in flows of physical and financial capital, while innovation requires both of these flows, as well as increasingly vigorous exchanges of human capital through engagement with the diaspora and the emigration of talented workers. However, these are not hard-and-fast rules. Some countries have succeeded in attaining high income levels without instituting the structural prerequisites needed to sustain them. They did so by getting rid of obsolete economic arrangements, by weakening the forces of preservation, and by creating the necessary new ones. However, it appears that these countries—such as Argentina and República Bolivariana de Venezuela—also find it difficult to ensure that their income gains are durable, and even more difficult to continue to close the gaps in living standards with economies at the global economic frontier.

Economic development = structural change

As described in chapter 1, the term “middle-income trap” refers to the risk of an economic slowdown or stagnation if a country fails to adapt its policies and institutions to changing economic and structural needs. Strategies based on factor accumulation alone are likely to steadily worsen results—a natural occurrence as the marginal productivity of capital declines. Even if all middle-income countries enjoyed the enabling conditions of peace, freedom, factor mobility, and rule of law, the returns from capital investment alone would decline too sharply to support the countries’ sustained and ongoing economic growth.

If capital endowments were the only economically relevant difference between middle-income and high-income countries today, the gross national income (GNI) of a typical middle-income country would be about 75 percent that of the United States. In China, for example, its investment to gross domestic product (GDP) ratios have been stratospherically high for decades, but its GNI is less than 25 percent that of the United States. Another way to understand the problem is that, although there has been considerable convergence in capital to output ratios between low- and middle-income countries and high-income countries, income levels have not converged. And so other factors are clearly at work. A simple decomposition of factor endowments and total factor productivity (TFP) reveals that the contribution of physical capital per worker diminishes at later development stages (figure 2.1). What really matters for growth is TFP growth, which is clumsy longhand for the effects of technological progress and improved efficiency in converting capital and labor into goods and services. In fact, much of the growth in the United States between 1909 and 1949—when it was a middle-income country—stemmed from technical change, not an increase in capital per worker.

If much of growth everywhere is the result of technical change, then conventional thinking would follow that every middle-income country needs to figure out how to quickly institute arrangements that foster technical progress, not only (or primarily) the accumulation of capital. But this interpretation is not helpful for policy making because of the ongoing importance of capital deepening across all categories of countries, but especially in middle-income economies.

In fact, the growth of middle-income countries depends on both capital accumulation and technical change, making the growth challenge twice as complex as it is for either low-income countries that primarily must focus on accumulation or high-income countries that must rely largely on technical change, even if a large part of it is in the form of new investment.

Infuse first, then innovate

How have the most successful middle-income countries engineered progress? Modern economic history provides one valuable lesson. Countries that have made technological advances and achieved high-income status did so through two successive transitions.

The first set of changes, described as infusion in this Report, dominates development strategies in rapidly growing lower-middle-income countries. Policy makers in these countries have emphasized importing modern technologies and business models from more advanced economies and diffusing this knowledge at scale in their domestic economy. These technologies and models have, often in short order, enabled enterprises to become regional and global suppliers of goods and services.

The second phase of structural change, commonly called innovation, occurs mainly in successful upper-middle-income economies. This transition involves a deliberate shift from imitating and adapting technologies used in advanced economies to building home country capabilities to change leading global technologies and products. An increasing number of domestic firms can become global knowledge creators and—eventually—leading innovators themselves.

The term infusion has been carefully chosen to connote both deliberately imitating technology and business practices from abroad and expediting their diffusion at home (figure 2.2). Not surprisingly, countries that have been relatively open to economic developments abroad and have been successful at instituting general secondary education and technical and vocational training programs at home have done better than those that failed to do one or both.

The mechanics of the innovation stage of economic development are more difficult, and so this stage has received much attention. Like others, this Report warns developing countries against attempts to “leapfrog” (that is, to prematurely attempt to transition) to the innovation stage (generally through the use of industrial policy interventions). What is more novel in this Report is its emphasis on the changing nature of knowledge exchanges and the successful impact of such exchanges on fostering development by benefiting from the international mobility, not only of capital and know-how but also of highly skilled people. The prerequisites needed to capitalize on the global nature of human capital—such as policies to attract entrepreneurs from the diaspora and ensure greater freedom of expression—are more difficult to institute and can stymie progress.

Successful infusion efforts have marked reversals of fortune in several parts of the world marred by war and violence:

• Postwar Europe. The onset of the European Golden Age was powered by infusion. The two world wars in the first half of the twentieth century destroyed much of Europe’s capital stock and skills. And the exodus of talent in the interwar years meant that Europe lagged behind the United States in technology. The Marshall Plan was developed to transfer technologies from the United States to Europe. European managers were sent to the United States to acquire skills, and businesses could obtain loans to purchase technologically advanced American capital goods under the US Productivity Program. As a result, Europe rapidly adopted modern technologies and best practices, allowing Western European countries to accomplish in 30 years what might otherwise have taken twice as long.

• Korea. An important component of industrial policy in Korea was incentives for technological investment. In particular, Korea subsidized the adoption of foreign technologies and innovation through tax credits. Specifically, firms received tax credits for royalty payments or research and development (R&D) expenditures. The policy first subsidized technology adoption when the technology gap with foreign firms was large. But as Korean conglomerates caught up with foreign firms, the approach gradually shifted toward supporting innovation. Korean policy makers ensured that public support was monitored and evaluated, and data on innovation grants were made publicly available.

• Malaysia. Malaysia became a successful industrialized country through infusion-centered and export-oriented growth that replaced import substitution policies in the mid-1980s. Technology embodied in foreign direct investment (FDI) was important for developing and structuring the country’s industrial base. Malaysia offered a spectrum of tax incentives to attract FDI through the Promotion of Investment Act in 1986. Malaysia’s growth in the 1980s was marked by large productivity gains from adopting and diffusing technology. But Malaysia did not perform as well as Singapore in attracting entrepreneurs of Malaysian origin living abroad.

As these examples show, infusion, tapping into global knowledge, and a country’s institutional structure play a key role in supporting the economic growth of middle-income countries beyond just increasing a country’s income per capita. And the key to infusion at scale is openness and exchange—through paths such as trade, FDI, pro-competition regulation, licensing, migration, and knowledge exchanges. A combination of investment and infusion can engineer high growth through investments in physical capital (infrastructure), structural change that improves the allocation of productive resources across firms and sectors, and technological convergence through the adoption and infusion of foreign technologies.

To undertake infusion at scale, however, countries need both globally competitive firms and specialized talent. As firms adopt newer technologies, their need for engineers, scientists, managers, and other highly skilled professionals increases. The variety and skill content of work also increase in middle-income countries (figure 2.3). In fact, the central feature of the Industrial Revolution and its aftermath was the slow shift from tacit knowledge that is not codified or easily expressed (as embodied in craftsmanship and simple production techniques) to more formal knowledge created by mathematicians, physicists, chemists, medical doctors, and people schooled in “engineering science.” Today, graduates from the science, technology, engineering, and mathematics (STEM) fields play a central role in generating and spreading ideas and technologies. Encouragingly, three-quarters of STEM graduates are now in middle-income countries, and Chinese and Indian STEM graduates make up about half of global STEM graduates (figure 2.4).

The example of Korea, the only country ever to sustain economic growth that averaged more than 5 percent for more than 50 years, is especially illustrative. How did Korean industry do it? Domestic firms such as Samsung embarked on a journey that began with infusion. By licensing technologies from Sanyo and NEC in Japan, Samsung transitioned from making noodles to manufacturing televisions for domestic and regional markets (figure 2.5, panel a). This transition created a higher demand for engineers, managers, and skilled professionals that was monitored, and the targets were met by the Ministry of Education through both providing the needed education in public universities and regulating private institutions. Korea also generated a demand for more specialized capital: for economies at the infusion stage, investment remains important.

The first World Development Report (1978) highlighted the need to differentiate between strategies of imitation and innovation in driving growth in middle-income countries. A large part of middle-income country growth happens through a combination of investment and imitation (see box 2.1 for a description of how Japan connected with global knowledge). But eventually the gains from imitation begin to subside. As an economy approaches the global technology frontier, policies that supported growth eventually become a burden for sustaining further development. When Samsung reached that point, it moved toward innovation—nudged by support from the Korean government, which had calibrated its incentives to encourage imitation first and support innovation much later (figure 2.5, panel b). To nurture innovation, institutions must give inventors and entrepreneurs incentives and ensure that they can acquire the technical and financial resources to carry out their designs.

Once a middle-income country has infused its economy with technology from global innovators and is sustaining rapid growth, it can aspire to converge to the global technology frontier by preparing to join those innovators—that is, to become an innovation economy. To reach this point, however, governments must have done everything possible in the infusion phase to not just prepare the economic structure for the different next stage, but also reform and strengthen supporting institutions. Those who falter in infusion or try to leapfrog will find it much more challenging to transition toward innovation.

A comparison of Estonia, Poland, and Bulgaria is illustrative. Transitioning from central planning, Estonia reached 80 percent of Western European income by 2021, Poland 75 percent, and Bulgaria 50 percent (box 2.2). Estonian independence in 1991 catalyzed a swift transition to high levels of innovation. By contrast, Bulgaria protected many incumbent state-owned enterprises (SOEs) from competition and stymied efficient resource allocation, preventing the contraction of low-productivity sectors. As for Poland, it privatized many of its SOEs and championed competition.

Middle-income countries lag noticeably behind high-income countries in terms of the “novelty” of their knowledge, as well as in producing new knowledge (figure 2.6). Innovation is concentrated in a handful of high-income economies: Germany; Japan; the Republic of Korea; Taiwan, China; and the United States. The magnitude and impact of new research in other countries is quite limited (figure 2.7).