World Development Report 2024: The Middle-Income Trap

The turning point for Japan’s rapid industrialization was the Meiji Restoration in the late 1800s. The -government embarked on a project, Shokusan Kogyo (industrial development and promotion of industries).a Under it, Japan began investing in modernizing infrastructure (such as telegraph, rail, and electricity) and deploying demonstration factories to facilitate private sector learning and technological diffusion and to assume the first-mover risks of deploying technology. Trade flows were a critical factor in launching Japan toward the technological frontier.

Government-sponsored trips to the United States and Europe were also instrumental in acquiring technical expertise from frontier countries. The 1871–73 Iwakura Mission to both areas proved critical to facilitating the knowledge transfers needed to push Japan to the technology frontier. The statesmen and students who participated set out to study Western institutions, economic structures, educational systems, and industrial capabilities. Although German and English industry impressed senior diplomats,b Mission staff took an interest in US applications of new technologies and the productivity gains reaped from such innovations.c

In 1888, engineers in the newly formed Ministry of Communications were dispatched to the United States, among other Western countries, to collect information on the state-of-the-art technology needed to construct the country’s telecommunications network.d The ministry officials who attended this trip visited US telecommunications firms such as Western Electric, brought back equipment such as switchboards, and urged the Japanese government to implement Western Electric’s systems for the country’s network.eForeign expertise was transmitted to Japanese students through foreign practitioners who taught in domestic technical schools (usually in English, indicating that some of the professors must have been American).f The government also sent engineering students to Western countries. By the end of the 1880s, one-quarter of the students who had traveled abroad had visited the United States.

Box 2.2 Three ways to evade the middle-income trap: Swiftly (Estonia), steadily (Poland), or slowly (Bulgaria)

Over the last three decades, Bulgaria, Estonia, and Poland have transitioned simultaneously from -central planning to market economies, and Estonia and Poland have moved from middle-income to high-income status.a By 2021, Estonia had reached 80 percent of Western European income, Poland 75 percent, and Bulgaria 50 percent.b This remarkable leap from income per capita of between 20 and 30 percent of Western European levels in the early 1990s occurred at different speeds, which provides valuable policy insights.

Policy insight 1: Comprehensive reforms unlock productivity and prosperity

Structural reforms, specifically privatization and market liberalization, have played a crucial role in speeding up income convergence among Central and Eastern European economies, as documented in an extensive cross-country study by Matkowski, Prochniak, and Rapacki (2016). They find that the rate of convergence has significantly benefited from enhancements of institutions, economic freedom, and governance quality. Higher investment rates, a skilled labor force, low budget deficits, and lower tax burdens have been associated with accelerated economic growth.

Estonian independence in 1991 catalyzed a swift transition to high levels of productivity growth driven by a strategic divestment of public sector assets, trade liberalization, and a flat tax system. These policies opened up the market for new entrants, attracted a surge in foreign direct investment (FDI), and boosted private sector productivity. The magnitude of FDI inflows to Estonia during the 1990s was seven times that to Bulgaria and three times that to Poland.c Estonia maintained its status as a leading innovator in the region, with the highest research and development (R&D) intensity—1.75 percent of its gross domestic product (GDP) in 2021—and a high ranking in the Global Innovation Index (GII).d

As for Poland, early “big bang” reforms, trade competition, and hard budget constraints for state-owned enterprises (SOEs) systematically activated a cycle of creative destruction, closing the gap with advanced countries, as evidenced by an increase in R&D expenditure to 1.3 percent of GDP in 2021, as well as higher GII scores.

Policy insight 2: Incentives for incumbents to drive innovation are crucial

Productivity growth is a dominant driver of income convergence. Between 1996 and 2021, Estonia displayed robust annual productivity growth of 3.8 percent, followed by Poland at 2.6 percent and Bulgaria at 1.4 percent. Lowering barriers to entry and streamlining regulation—enhanced by accession to the European Union (EU)—have initiated a virtuous cycle that has sustained productivity growth. In this cycle, competition spurs innovation, which then fuels further competition, ultimately raising societal well-being.

During Bulgaria’s initial phase of its transition, many incumbent SOEs were shielded by regulatory safeguards and anticompetitive practices. This environment hampered productivity growth by delaying the shift of resources toward more productive sectors. Throughout much of the period preceding EU accession, growth among Bulgaria’s high-productivity industries was limited. At the same time, low-productivity sectors that relied on low-skilled labor—such as construction, retail, and ground transportation—-continued to expand. Unlike Estonia and Poland, Bulgaria took nearly a decade longer to free up resources for more productive uses. Even now, some industries benefit from regulation that inhibits healthy competition.

Poland’s mass privatization program is a compelling example of how to catalyze a virtuous cycle of competition and innovation, despite some challenges. By redistributing equity from more than 500 SOEs—which constituted up to 5 percent of the nation’s wealth—to 27 million citizens, Poland created incentives for both new and established companies to champion competition. In Poland’s early transition, the implementation of hard budget constraints, established so that SOEs would avoid reliance on unlimited government support, led to a monumental shift in attitude toward market competition. Even iconic SOEs such as the Stocznia Gdańsk shipyard, where Lech Walesa’s Solidarność (Solidarity) movement began, triggering the collapse of communism in Central and Eastern Europe, were not bailed out. The alignment of managerial incentives—both explicit and implicit—propelled creative destruction. Managers at Polish SOEs shifted their attention from production targets to profitability and market share.e These managers became the primary agents of restructuring and innovation, facing both financial constraints and competition.

Policy insight 3: Skilled labor is essential for moving from infusion to innovation

As economies mature, the returns from capital become dependent on a supply of sophisticated workers. Continual enhancements in firm efficiency and workforce skills are vital to staying competitive in the rapidly changing productivity landscape.

The success stories of Estonia and Poland illustrate strategic ways to close the technology gap—-initially by adopting existing technology and subsequently by developing innovative capacity. Poland narrowed its productivity gap primarily by adopting older technologies from more advanced economies rather than through the transfer of new, cutting-edge technologies.fDomestic investments in innovation further accelerated Poland’s move toward the technology frontier, enhancing firms’ ability to contribute to global technological progress. Labor also played a critical role in the transformation in Poland, according to a breakdown of the growth in total factor productivity.g A notable 20 percent of the contribution came from labor alone, a figure driven not by a reduction in workforce numbers but by the enhanced quality and diversity of the labor force. A significant rise in the proportion of individuals between the ages of 25 and 34 with a tertiary education, which increased from 15 percent to 42 percent between 2000 and 2012, had a significant impact on output growth.h

Bulgaria’s experience illustrates how shortages of skilled labor can impede new investment and the growth of high-productivity ventures. The educational landscape in Bulgaria has lagged in quality, participation, equity, and intergenerational mobility. Certain segments of the population still struggle with the acquisition of basic skills, undermining their potential contribution to productivity. Prioritizing human capital development to take advantage of adoption and innovation is essential, especially in view of the demographic changes in many middle-income countries, which are at risk of “growing old before becoming rich,” as the saying goes.

a. Gross national income (GNI) per capita and gross domestic product (GDP) per capita data in this report are as of July 2023. As of July 2023, Bulgaria was classified by the World Bank as an upper-middle-income country, with a GNI per capita (Atlas method, current US dollars) of US$13,350, short of crossing the high-income country threshold of US$13,846.

b. These figures are measured using purchasing power parity for the four largest EU economies.

c. These figures capture net FDI per capita accumulated by the end of 1999.

d. See GII (Global Innovation Index) (dashboard), World Intellectual Property Organization, Geneva, https://www.wipo.int/global_innovation_index/en/.

To support innovation, countries will have to find ways to make existing firms (incumbents)—both industrial conglomerates and economic elites—innovative and more productive and to make way for newcomers. To be sure, the emerging markets are already hotbeds of entrepreneurial activity. Novel products are being used by millions, and new production methods are increasing consumer choices and lowering prices. Jack Ma, cofounder of China-based Alibaba, and Narayana Murthy, cofounder of India-based Infosys, have grown their enterprises to scale and created thousands of jobs by successfully competing in global markets and even pushing the technology frontier outward. Still, too many markets are hobbled by excessive business regulations, government patronage, and limited international competition. In such an environment, powerful owners and unproductive large firms can stifle growth, lobbying to protect their preferential access and monopoly rents when they could instead be investing in productivity-enhancing technology.

As policy makers shift their emphasis toward innovation, they should first combine a lot of investment with a lot of infusion (box 2.3). And they should not bet the farm—or even a field—on leapfrogging. Infusion is imperative. A review of the literature on middle-income traps highlights that countries often try to make premature leaps from investment to innovation. According to Gill and Kharas (2015, 28–29),