World Development Report 2024: The Middle-Income Trap

Although large incumbent firms can spur as well as block the forces of creation, large incumbents do not capture the broader economic landscape in middle-income countries. Most establishments are microenterprises that neither grow nor exit, and therefore they do not contribute to growth in productivity. Furthermore, many medium and large firms that have the potential to leverage the incumbency advantage to lead infusion and innovation often achieve scale by benefiting from distortions rather than from merit (see next section for that discussion).

“Flat and stay” and “up or out” describe entrepreneurial dynamics. One reason for the lack of business dynamism in the economies of middle-income countries can be traced to the typical life cycle of a firm’s growth (figure 4.8, panel a). In the United States, a celebrated feature of the economy is the selectivity of its markets. Start-ups and young businesses are confronted by pressure to move up or out. The average young US firm grows by a factor of 7 by age 40, assuming it is still in business. Failing entrepreneurs either move up to newer ventures, or out to find wage-earning opportunities by means of the rising labor demand in flourishing firms. By contrast, in middle-income countries flat and stay is a more accurate description of entrepreneurial dynamics. The growth rates of firms in India, Mexico, and Peru are far lower than those of firms in the United States, with firms expanding by less than a factor of 3 (figure 4.8, panel a). Conversely, when firms with growth potential lack dynamism, they fall short of displacing unproductive small firms from the market. This absence of creative destruction results in a stark contrast: although the share of small firms with at most four workers declines by 60 percent by the age of 25 in the United States, the decrease is only about 10 percent in India (figure 4.8, panel b). Consequently, the Indian economy lacks the mechanism for effective selection among firms, hindering the reallocation of resources to more productive users.

Box 4.1 Vibrant corporate R&D, connected places, mobile people, and successful markets for patents: How the United States nurtured an innovation ecosystem

The US economy has fostered innovation for centuries, inspiring numerous inventors to generate brilliant ideas that have, subsequently, been harnessed by businesses to create consumer products or production technologies that have had a widespread impact. Four dimensions have been important:

• Who “creates” has shifted from small, independent inventors to corporate research and development (R&D) and innovation. Over the last 150 years, there has been a remarkable transition from the realm of “garage inventors” to the corporate R&D facilities of modern corporations (figure B4.1.1). The transition has coincided with the growing sophistication of the US economy.

• Connected places are more inventive. Connectivity enhances the market size for innovation and the flow of knowledge. Inventive activity in the early nineteenth century accelerated in US locations that were near navigable waterways and had developed railroads.a

• The migration of people is critical to innovation. Technology sectors in the United States with a higher concentration of immigrant inventors between 1880 and 1940 experienced accelerated growth from 1940 to 2000.b Furthermore, immigrant inventors exhibited greater productivity throughout their careers than their native-born counterparts. Unfortunately, despite their heightened productivity, immigrant innovators found that their earnings were much lower.

• The secondary market for innovations (such as patent resale or licensing) is as important as innovation itself. This secondary market has played an outsize role in the United States. Between 1870 and 1910, inventors increasingly sought the services of the more than 500 specialized registered patent agents nationwide to navigate the intricacies of patent-related transactions. For example, Edward Van Winkle, a mechanical engineer who pursued a law degree via correspondence courses, -possessed the ideal skill set to provide clients on both sides of the market with expert advice on the legal and technical aspects of inventions. He established a network of businessmen, inventors, and fellow lawyers to broker patent deals between buyers and sellers.c

a. For waterways, see Sokoloff (1988); for railroads, see Donaldson and Hornbeck (2016) and Perlman (2015).

c. For historical markets for technologies, see Lamoreaux and Sokoloff (2002). For more contemporary markets, see Akcigit, Celik, and Greenwood (2016).

The life cycle dynamics of firms exhibits a similar flatness when expanding the sample to include a few East European and East Asian economies (figure 4.8, panel a). Serbia and Malaysia seem to have stabilized at a notably lower level of life cycle growth than the United States, comparable with the dynamics of the other middle-income economies in the figure. Viet Nam seems to be at a critical point at which it either continues its promising trend and accompanies a similar degree of dynamism as observed in the United States, or it succumbs to the lackluster performance characteristic of the middle-income trap.

The weakness of firm dynamics in middle-income countries translates into stark differences in the distribution of firms across sizes (figure 4.9). In the United States, microenterprises are the dominant form of production in terms of share of firms, but firms are distributed more uniformly across the size spectrum. Start-ups enter small and proceed to grow up or get out, which explains the prominence of medium and large firms. In India, Mexico, and Peru, the flat and stay behavior translates into a market in which more than 80 percent of firms employ fewer than five workers each.

Informal establishments account for most of the microenterprises in the firm size distribution in India, Mexico, and many other countries. Although informal entrepreneurs may have had greater success at growing and becoming formal if the costs of business entry were lower, attempts to reduce the costs of business entry for firms in developing countries have had modest results at best. Instead, the large informal sectors in many middle-income countries reflect a misallocation in jobs whereby distortions in firm growth reduce wages and wage-earning opportunities in the formal sector. Such distortions misallocate resources from their best use and discourage incentives to adopt and innovate technologies. This vicious cycle, in turn, reduces higher-paying formal wage jobs and further fuels informality.

Middle-income countries are not benefiting from technological disruption by their smaller firms. This outcome challenges the commonly perceived notion that micro- and small enterprises are the drivers of job creation and economic dynamism. That misconception is compounded by the fact that start-ups are primarily small. However, age, not size, should be the measure used to assess dynamism. In fact, in the United States small firms are the net destroyers of jobs, except for start-ups younger than a year—they are not the net creators (figure 4.10).

How governments stifle firms’ incentives to grow, infuse global technologies, and innovate

Most firms in middle-income countries are small, do not grow, and do not exit the economy. This lackluster performance is due, in large part, to government policies that interfere with the forces of creative destruction. Governments often use outdated rules of thumb to identify who creates value, and they lack the information and capabilities to identify key constraints to the growth of productive firms. When size is used to target larger firms to advance social objectives, the incentives to grow are dampened. As a consequence, an economy produces far below its potential.

Adopting and developing technologies are costly endeavors, and so entrepreneurs will incur these costs only if rewarded with a sufficient rate of return. When governments effectively lower the rate of return to adopting and developing technologies, they undermine the whole economy’s production possibilities relative to the potential frontier, locally and globally.

Screening firms by size—not by their ability to create value—often ends up being misguided. Talented entrepreneurs are not able to attract more capital and labor, jobs shift from high-productivity firms to low-productivity ones, and value creation declines. Compounding this effect is the more consequential one of reduced upgrading, which lowers the number of firms that have the ability to grow.

Outdated rules of thumb stifle progress

The goals of protecting small businesses and preventing the concentration of economic power have motivated many countries to implement policies based on firm size (size-dependent policies). By using size to screen which firms should be protected and which firms should be penalized, policy makers end up taxing firms that create value (box 4.2). A firm that creates value attracts capital and workers—it grows in size. Thus a policy that screens by size is effectively a policy that curtails productivity and value creation. Such policies keep productive firms smaller and less productive firms larger than they should be based on their technical capabilities.

Box 4.2 Examples of size-dependent policies

In some countries, smaller firms below a specific size are exempt from regulations or taxation. In other countries, once the firm exceeds a specified size threshold, it faces higher taxes and more regulations. In extreme versions, such policies restrict the production of certain items to firms of a given size.

Many other policies and market frictions may also result in a size-dependent distortion based on the abilities of firms of different sizes, productivity levels, and internal wealth to circumvent such policies. For example, stringent collateral requirements for business loans disproportionately affect young, productive firms with strong borrowing needs but little history of retaining enough earnings to accumulate internal wealth.

Some examples of explicit size-dependent policies in various middle- and high-income countries follow. Although individual policies like these, in isolation, may have only a minor effect on the full extent of misallocation and lack of innovation in middle-income economies, explicit size-dependent policies may interact with implicit size-dependent distortions and reinforce one another. For example, a regulation that increases the fixed and variable costs of labor for firms with 50 or more workers (an explicit size-dependent distortion) may coexist with a financial market that imposes tighter credit standards on young businesses and for loans aimed at financing intangible capital investments such as research and development (an implicit size-dependent distortion). The overall degree of resource misallocation and underinvestment in innovation is the outcome of multiple distortions interacting and reinforcing one another.

Mexico. Mexico’s income tax law created REPECO (Régimen de Pequeños Contribuyentes), a special provision for small businesses based on their level of sales. For ordinary firms whose sales exceed the threshold, the tax on capital income amounts to 38 percent (28 percent for the government and 10 percent for profit-sharing with employees). Firms with annual sales below US$163,000 (Mex$2 million) do not have to pay the capital tax, but instead pay a 2 percent sales tax, with 7.5 percent of the 2 percent sales tax directed to the profit-sharing scheme. Once the sales of a REPECO firm exceed the threshold, it cannot become a REPECO firm again.a

Türkiye. Türkiye’s labor and safety laws impose several regulations that apply to firms above certain size thresholds. Firms employing more than 50 workers must establish a health and safety board; set up a health unit and hire physicians and other health staff; and employ disabled workers and formerly convicted workers.b

India. Small-Scale Reservation Laws in India are the poster child of a size-dependent policy that fosters misallocation and discourages innovation.c Since 1960, the government of India has “reserved” the production of many manufactured goods for small-scale industries only. The definition of a small-scale industry is based on an industry’s cumulative investment in plant and machinery. Effectively, all establishments with plant and machinery below a specific limit have been considered small and allowed to produce the reserved goods. Although the number of products falling into the reserved category increased steadily between 1960 and 2002, the policy has been progressively dismantled, with only 20 products remaining under the reservation law in 2010.

Peru. Various labor laws in Peru are size-dependent. For example, a profit-sharing -agreement applies to firms with more than 21 salaried workers. The fraction of profits to be distributed ranges from 10 percent in manufacturing to 8 percent in mining, retail, wholesale, and restaurants. Workers can join a firm-specific union of at least 20 members, exposing firms beyond this size to the unionization of their workforce. And firms exceeding 20 employees must set up a health and safety committee.d

Portugal. The average size of firms in Portugal fell sharply between the mid-1980s and mid-2000s. Size-dependent policies may have contributed to such a dramatic shift in the production structure.e Notably, firms with less than 50 workers are allowed to pay up to 50 percent less than the minimum wage, are subsidized in hiring young workers, and receive support for worker hiring. Firms with more than 50 workers must maintain a worker health protection system.

Italy. Italy’s Employment Protection Legislation imposes a disproportionately higher cost on firms employing more than 15 workers to fire workers. Firms with fewer than 15 workers must pay a dismissal cost equivalent to between 2.5 and 6 months of salary in cases of unjustified firing. Firms with more than 15 workers must compensate workers for forgone wages between the time of dismissal and the court’s sentence. Dismissal trials can last up to five years, and there is no upper limit on the amount of forgone wages.f

France. Labor laws in France apply special provisions to firms with more than 10, 11, 20, or 50 employees.g In particular, as a firm reaches 50 employees, a committee for hygiene, safety, and work conditions must be formed and trained; a works council must be formed and meet at least every other month; and a higher payroll tax rate, which goes from 0.9 percent to 1.5 percent, subsidizes worker training. In addition, if a firm fires more than nine workers for “economic reasons,” it must follow a special legal process, which increases dismissal costs and creates legal uncertainty for the firm.

Republic of Korea. When a firm is classified as a small or medium enterprise (SME), it can receive about 160 benefits from the SME support policy. Benefits include differential corporate tax rates, tax relief benefits, and government-guaranteed loans for SMEs.h

An example is the Small-Scale Reservation Laws implemented in India between the 1960s and early 2000s. The laws stipulated that most manufactured goods could be produced only by small-scale plants, defined as those whose capital stock did not exceed a government-set threshold. This policy was complemented by several additional benefits for small-scale enterprises, such as the Private Sector Lending Program, in effect until the 1990s, which stipulated that commercial banks had to allocate up to 40 percent of their private credit at subsidized rates to small firms. In Peru, the constitution and legislation require firms with more than 21 workers to distribute a portion of their before-tax profits to their formal labor force. And, in France, firms with more than 50 workers pay a higher payroll tax rate and must comply with additional regulations. Such programs create perverse incentives in terms of resource allocation and innovation. They also contribute to increased informality in developing countries.

Turnover taxes that tax intermediate and capital goods and corporate taxes, even when set at uniform rates, are also examples of size-dependent policies in the way in which they are enforced. Larger firms are more likely to face tax enforcement in low- and middle-income countries, whereas this practice is almost absent in advanced economies.

In terms of credit, when contract enforcement is weak and secured transactions and bankruptcy laws are poorly designed and enforced, banks may demand higher interest rates, impose more stringent lending standards, and tighten their collateral requirements. Some firms may have more collateral to pledge and thus may not be affected by the financial requirements. Others may have accumulated enough internal liquid funds to cope with the pressing needs of working and physical capital without financial intermediation. However, for many other firms credit is necessary. Tighter collateral constraints hamper these firms’ abilities to scale up to the level merited by their capabilities. It is usually young entrepreneurs with innovative business ideas but without collateral they can pledge who are most negatively affected (box 4.3).

Box 4.3 The productivity effects of credit misallocation and capital market underdevelopment

A concerning feature of credit markets is the misallocation of credit away from the most productive businesses in middle-income economies. More productive firms in these countries receive lower amounts of debt and equity financing than merited by their technical efficiency, a property that is less prevalent in high-income countries (figure B4.3.1). In Mexico, for example, access to finance across firms favors the least productive over the most productive firms.a

Another feature of developing economies is the underdevelopment of capital markets. Unlike bank-provided credit, debt and equity financing are associated with productive investments by firms, leading to expansions in infusion, innovation, and physical capital.b By excessively relying on banks for financial intermediation, middle-income countries are limiting their capable firms to access finance.

Episodes of capital account liberalization, opening middle-income countries’ economies to foreign capital financing, can reduce the misallocation of capital.c For example, India’s capital market liberalization contributed to a more efficient allocation of resources across firms over the last 20 years.

More broadly, these rules of thumb impose a hefty tax on productive firms, a practice known as “taxing the good” (figure 4.11). By discouraging the expansion and growth of firms, these policies also discourage the adoption of modern management practices, a necessary condition for improving efficiency and adopting technologies. Alfred D. Chandler, Jr., a renowned economic historian, suggested that one of the critical transformations in the US economy between the mid-1880s and World War I was the replacement of the traditional family enterprise with the modern multiunit enterprise managed by a complex layer of top- and middle-management structures.

Countries with a higher quality of management practices—as measured by the World Management Surveys—have lower productivity-dependent distortions (figure 4.12). In the United States, a firm’s managerial capabilities are central to its ability to grow and innovate. However, in most middle-income countries, managerial capabilities of firms are underdeveloped. The exceptions are a handful of countries that have enjoyed sustained growth accelerations.

Benefits extended to state-owned enterprises hurt private enterprise

When countries are early in their development journey, the state favors its SOEs for undertaking ventures in the market. However, these preferences hurt private enterprise. Although SOEs benefit from lower costs of labor and capital, this benefit increases the cost of production for their private counterparts, which are often more productive. Benefits extended to SOEs not only misallocate resources away from more productive firms but also discourage the private sector from investing in costly initiatives (such as R&D) to become more innovative or produce more innovative goods or services. SOEs in manufacturing and contestable service industries have become a source of resource misallocation.

In the critical area of energy supply, electricity continues to be delivered primarily by SOEs. In 2020, 60 percent of 125 low- and middle-income countries still relied on a public distribution utility. The role of SOEs in fossil fuel power investment increased from 43 percent to 50 percent from 2015 to 2019, notably due to the expansion of coal plants in India and South Africa and gas plants in the Middle East and North Africa.

Preferences for incumbents block progress

Large enterprises are important drivers of innovation and are able to imitate at scale. However, weak institutions may encourage these firms to protect their profitability by deterring competition rather than innovating their way out of competition. A firm’s market power and incentives to abuse its dominance are shaped by features of the market, government interventions, and its strategic behavior.

The problem is not the market power of some firms per se, but the exercise of dominance that undermines effective competition, dampening innovation, harming consumers, and driving equally efficient competitors out of the market (table 4.1). Market leaders can also acquire smaller competitors to wind down the operations of potential competitors, such as in the pharmaceutical industry. Market power becomes problematic under the following conditions:

• Market power is not the result of innovation. For example, politically connected firms in Italy’s local markets changed their behavior as they grew. Rather than innovating and competing with other firms, they brought local politicians onto their payroll. At the same time, their innovation (measured in terms of numbers of patents) began to decline.

• Market power is sustained over time by government interventions that protect a firm or provide it with specific advantages. In Mexico, for example, although the telecommunications sector was open to competition in 1995 after 20 years of public monopoly, followed by five years of private monopoly, it was not until 2014 that the government imposed the first obligations on Telmex and Telcel as operators with significant market power. The inability of the sector regulator and the competition authority to impose such conditions in previous years made its owner, Carlos Slim, the richest man in the world between 2011 and 2013, according to Forbes magazine. Similarly, overly long concession contracts for limestone and restrictive standards for cement helped Aliko Dangote become the richest man in Africa.

• Market power is sustained over time by illegal strategic behavior, such as when dominant firms exclude their rivals from the market or when a few firms agree to collude. Anticompetitive practices that close entry and place competitors at a disadvantage are common in digital platform markets.

If large incumbent firms are not disciplined by means of regulations that promote competition or antitrust rules, firms with market power are more prone to abusive practices—such as predatory pricing, price squeezing, or denial to supply other competitors—contributing to a decrease in competition. Although many competition authorities have the mandate to sanction anticompetitive practices, prevent anticompetitive mergers, and provide policy advice to eliminate regulatory restrictions to competition, not all competition authorities in middle-income countries have the resources needed to enforce their mandate. For example, although Brazil, China, India, Mexico, and South Africa have a wide range of resources such as enforcement tools, budget, and staff, authorities in Bangladesh, Malaysia, Morocco, and Nigeria have limited resources.