World Development Report 2024: The Middle-Income Trap

An economy that is functioning well allocates factors of production to the most productive firms. In developing countries, the reallocation of factors of production has been an important driver of productivity growth, accounting for about 25 percent of the growth in efficiency. The ability of middle-income countries to catch up will depend on how well they attract and adopt leading technologies and facilitate reallocation of resources toward growing, productive firms and industries. Countries at lower levels of development have more opportunities for potentially productivity-enhancing reallocation as workers move from less valuable and less productive activities toward more productive ones (figure 8.2). Evidence from 21 European countries reveals that countries that experience the highest growth in terms of increases in GDP per capita are those with the highest job reallocation rates.

Business dynamism is characterized by an up-or-out dynamic; entrants exit at disproportionally high rates, but those that survive grow quickly, on average. The most successful firms mature and grow larger, displacing less productive firms. Potentially high-productivity firms must decide whether to invest in the managerial and technical capabilities or the R&D required to raise efficiency and product quality. Distortions in the operating environment have a substantial impact on firms’ decisions. The benefits of reallocating resources through potentially high-productivity firms not only helps the firms themselves, but also boosts job and output growth and creates positive spillovers for other businesses along the value chain.

Policies in many middle-income countries, however, are not compatible with rewarding merit activities. Such policies thus need to be revisited and upgraded.

Moving away from coddling small firms or vilifying large firms

Subsidies to SMEs are widespread in middle-income countries. Governments may enact such subsidies hoping small firms will grow, creating more jobs and growth. Many subsidies seek to reduce small producers’ operating costs through special credit terms and tax exemptions. But the same distortions also reduce the incentives for a productive firm to expand, deterring it from scaling up production.

Many firms in middle-income countries remain small even when long-established; they simply do not aspire to grow. The abundance of small firms in middle-income countries does not solely mirror the challenges they face. Instead, it indicates a deficiency in competition, originating from larger firms that would have displaced them in the market if they had expanded. Blanket support for small firms can curtail the exit of unproductive small businesses, perpetuate smallness, crowd out other firms, and misallocate resources. In Sri Lanka and Viet Nam, the provision of targeted subsidized loans and financial assistance reduced total factor productivity (TFP)—a measure of the efficient allocation of resources. In Mexico, policies to support SMEs have been associated with talent misallocation and reduced labor productivity. A long-running program in Japan documents that SME support programs reduce incentives for SME growth, thereby reducing job creation.

Ideally, government support would help SMEs grow into larger, more productive companies that pay higher wages and adapt knowledge instead of perpetually supporting small firms. To help SMEs grow, support programs must identify firms with genuine constraints to expansion and productivity growth and alleviate specific constraints. Improved data and information, along with analytic capability, are necessary to identify firm-specific constraints.

And yet enforcement of tax codes often tends to lump firms together by size. Even where tax codes do not create explicit provisions based on firm size, middle-income countries may be creating a practical subsidy to SMEs through size-dependent tax enforcement: governments with weak tax collection capacity may concentrate enforcement on larger firms. In Türkiye, enterprises with 50 or more workers must comply with labor and safety laws that include establishing a health and safety board and hiring physicians and other health staff and setting up a health unit. In fact, between 1994 and 2014 more than 70 countries created special enforcement units for large taxpayers, in addition to the 18 countries that already had such units in 1994 (figure 8.3). This development is part of a growing trend of taxpayer segmentation, recommended by international institutions.

Research has revealed that if firms were to comply with size-dependent tax policies, in 140 countries employment growth would drop by 25 percent. Conversely, removing size-dependent taxation would lead to TFP gains of about 1 percent, on average, and up to 2.3 percent for more distorted economies. For example, in Mexico eliminating distortions created by size-dependent taxation policies favoring small firms could boost output by 9 percent. In Chile, China, and India, reductions in distortions helped these economies close the gap between actual and potential productivity by 10 percent. Figure 8.4 illustrates the value of the actual level of manufacturing TFP in each country relative to the potential level if resources were allocated efficiently—that is, if the economy was on the production possibilities frontier. More important, reforms of size-dependent policies increase the return to skills and encourages technology adoption and productivity in the longer term.

Letting go of unproductive firms

Letting inefficient firms and business models fail is a core principle of creative destruction. Literature on firm exit—stemming from seminal work by Hopenhayn (1992)—shows that the exit of less productive firms contributes substantially to raising aggregate productivity. In many countries, during periods of trade liberalization the exit of the least productive firms has boosted growth.

In middle-income countries, however, bureaucratic frictions prolong the survival of zombie firms—inefficient, debt-ridden companies that crowd out investment by productive firms. Reforms to bankruptcy laws can prevent unproductive incumbents from turning into zombie firms and should focus on enabling failed businesses to exit swiftly and predictably and on allowing viable businesses to restructure.

More generally, the shedding of outdated arrangements—enterprises, jobs, technologies, private contracts, policies, and public institutions—is essential for reallocation, innovation, and growth. Economic downturns sometimes create a much-needed opportunity for older, less productive firms to make way for newer, more productive ones. A key Schumpeterian insight is that the creation of new industries does not go forward without sweeping away past realities.

Modernizing organizational models to manage firms

As barriers to growth are removed and resources are better allocated toward firms that add value, firms will need to make some strategic decisions. Firm owners aspiring to expand must delegate managerial tasks to professionals. Delegation necessitates strong legal institutions to establish and enforce contracts between owners and managers. These contracts should give managers incentives to work hard and should hold them accountable for any wrongdoing. Such arrangements encourage firms to increase their investments in expansion. As productive firms expand, creative destruction eliminates unproductive firms, driving up market compensation for managers within those expanding firms. The opportunity to earn more, in turn, encourages capable young individuals to invest in accumulating human capital to ensure a brighter future and enhances opportunities for everyone.

Capable professional managers can make sound decisions in their daily operations, think strategically, and manage human resources efficiently. In small firms, good management practices include keeping separate household and business accounts and monitoring inventories. In larger firms, they include rewarding good employees, setting production targets, deciding on product varieties, and monitoring performance. The impacts of better management are critical not only to individual firms but also to countries. Managerial quality accounts, on average, for about one-third of the gap in TFP between the country at the lead of the technology frontier, the United States, and other countries. In fact, Spain’s rapid growth from an economic backwater in Europe to a developed nation was backed by technology adoption and improving managerial capabilities (box 8.4).

Box 8.4 Catching up by opening up and modernizing firms: The Spanish growth miracle

Spain grew rapidly between 1950 and 1980, becoming a high-income economy in the late 1970s. Over those three decades, its output per capita increased from 27 percent to 57 percent of that of the United States. How did Spain achieve rapid catch-up? Political stability, a necessary condition, helped. But economic policies remained unreformed, state-owned enterprises remained a significant part of the economy, and rent-seeking by incumbents remained rampant. Spain’s auto industry—which is one of the world’s largest car exporters, the country’s largest export sector, and one of the country’s largest employers—offers three notable lessons.

First, although the domestic market for cars remained protected, Spain opened up to foreign direct investment to attract large investment in a new plant by Ford. The authorities reduced the local content requirement but set a minimum size of production, established an export ratio, and capped the number of cars that Ford could sell domestically. Overall, incentives were aligned to learn from global technology and organizational structures. The venture was disciplined by the need to export in global markets.a

Second, addressing complementary bottlenecks also helped.b Ford was able to export its large production of cars because the port of Valencia operated smoothly. The port was capitalized enough to respond to the demands placed on it.

Third, technology adoption and a greater focus on management techniques proceeded rapidly, and efficiency gains quickly materialized, supported by a well-trained cadre of local professionals and entrepreneurs who were ready to adopt and adapt the new technology to the realities of Spain.

Eventually, the opening up of Spain’s economy helped speed up the “creative destruction” that is central to structural transformation.

a. There are significant parallels with the operation of Korean chaebols as conduits for technology diffusion.

Improving general education is the first step toward promoting managerial skills, as discussed earlier in this chapter. In emerging economies, firms with more educated owners tend to have better business practices, and more educated entrepreneurs start firms that are larger and grow faster.

A second step—which can provide benefits sooner—involves training and information interventions. Training can be provided in a formal classroom or by means of in-firm consulting. Classroom-based training is the most popular method among small firms. In-firm consulting yields high benefits to larger firms, such as in Colombia, India, and several other countries. Consultants diagnose management practices and provide recommendations accordingly. Positive effects can emerge within one year and tend to last for several years—although they sometimes disappear when the manager who adopted them leaves the firm. These interventions are highly effective, but they are also relatively costly. The costs can be reduced by providing group-based consulting.

Entrepreneurs in middle-income countries often rely on family and social networks to maintain business relationships and run their enterprises, but this practice hampers their ability to grow. Even for large publicly traded firms, how a firm is controlled can be traced back to the country’s legal origins. The share of family-controlled firms is highest in countries that have adhered to the French civil law system, followed by countries that have adopted the German civil law system and civil law countries in Scandinavia. Shareholder protection rights—provisions of corporate law that allow shareholders to take legal action against managers who abuse their position—are systematically linked to dispersed patterns of ownership, which can lead to better management. In the absence of solid shareholder protection, family control and management of a firm offer protection against abuse by management. However, in family firms with lower-quality governance, management quality is substantially lower.

Even among publicly listed corporations, family control is more likely in countries where organized labor is more powerful and collective dispute-resolution mechanisms are stronger. After all, it is easier to collude when corporate control is concentrated in the hands of families and organized labor. Management quality also varies with labor regulations and organization. In the United States, stronger union power weakens the ability of managers to use desirable performance incentives. Across countries, people management practices are weaker in those with more restrictive labor regulations. Revising laws and regulations related to corporate governance may be necessary to support entrepreneurship and good management.

Connecting entrepreneurs with money, mentors, and markets

Entrepreneurs in middle-income countries are the main protagonists of Schumpeterian growth through creative destruction, but these entrepreneurs are often disconnected from finance, as well as from networks of other entrepreneurs who can mentor them and help them access markets. Information asymmetries and lack of collateral hobble their potential. For this and other reasons, there is a paradox of low entrepreneurship amid great opportunity in emerging economies:

Like any investor, an entrepreneur is fundamentally placing a bet, comparing an entrepreneurial project with an expected range of returns and risks against other alternatives, such as “safe” salaried work, which is the opportunity cost of entrepreneurship. This implies both a process of managing risk and a process of learning—about the investment, about running a firm, and about evaluating and managing risk.

Approaches aimed at supporting entrepreneurship in developing countries are hampered by a “missing middle.” On the one hand, there has been a drive in development policy to focus on informal businesses or microentrepreneurs oriented toward survival. On the other hand, there has been a fascination with high-tech entrepreneurs in a handful of hot spots. What is missing is a clear-eyed assessment of the barriers facing growth-oriented entrepreneurs in middle-income countries—the protagonists of Schumpeterian growth. Three barriers are paramount: money, mentors, and markets.

Money. Lack of targeted finance is a fundamental reason why many opportunities in middle-income countries do not lead to more growth-oriented entrepreneurship. Improving access to finance is not only about extending credit; it is also about backing a money-making idea implemented by capable founders and managers. But it is difficult to gauge these dimensions. For example, a study of a large business plan competition in Nigeria found that even after an initial screening, expert judges, machine learning models, and economic models had very low abilities to predict which firms would grow the fastest over the next three years. Female founders of firms face particular biases and obstacles. In general, project evaluators place a lower value on the competence or leadership potential of women than of men, and investors inquire more about risks when dealing with female founders than with men.

Information asymmetries and lack of collateral are especially constraining for entrepreneurs with new ideas, regardless of whether those ideas are imitative or innovative. Equity markets can be instrumental in supporting innovative activities, especially in private firms, which typically face larger financing gaps than publicly listed firms. However, private markets for equity financing lack depth and access in emerging economies (figure 8.5). Private equity markets also make it easier for entrepreneurs to cash in on their investments and move on to a new project, should they choose to do so. Often, entrepreneurial ventures do not perform as planned, but the costs of exiting are very high, and the entrepreneur is held responsible for the entire downside risk of a failed endeavor, leading to reputational and financial downfalls. This is a great disincentive to risk-taking.

Mentors. Although money is important, entrepreneurial success is not all about the money. Most entrepreneurs need to be connected with networks of entrepreneurs—those at their stage as well as successful ones—to fully assess whether they and their ideas are fit for entrepreneurship. Data reveal that start-ups collaborating with seasoned venture capitalists tend to exhibit superior performance. Accelerator programs are a relatively recent addition to the variety of programs that direct knowledge, social, and financial capital to promising people and ideas. They provide training and technical assistance, along with mentorship and networking support, and offer certification, thereby reducing information asymmetries between entrepreneurs and investors.

Y Combinator, launched in 2005, is widely regarded as the first accelerator program. Its website stated: “You can’t make people something they’re not, but the right conditions can bring out the best in them. And since most people have way more potential than they realize, they’re often surprised by what they’re capable of.” A highly competitive process allows founders to join a three-month program of capability assessment and upgrading in which their ideas are pitched to investors. After the program’s inception, 5,000 US-based start-ups accelerated between 2005 and 2015 raised nearly US$20 billion in venture capital.

Accelerators have made their way into emerging markets, helping entrepreneurs access early-stage investment. But beyond investments, accelerators are “schools for entrepreneurs” that give competitively selected participants opportunities to build their capabilities—including through business training, networking, and mentoring—and sometimes supply funding.

Researchers associated with the Global Accelerator Learning Initiative (GALI) compiled information on 2,455 ventures that applied to 43 accelerator programs between 2013 and 2015, about half in high-income countries and half in emerging markets. After one year, participating ventures report higher revenue and employee growth, as well as higher equity and debt investment growth, compared with ventures rejected from the application pool. Surprisingly, the major gains for accelerated ventures in emerging markets are in leveraging debt, not equity. Furthermore, emerging market entrepreneurs rarely indicate that connections made during a program help grow their networks. They also tend to place more emphasis on business skill development. However, program managers in emerging markets report difficulties in recruiting mentors and advisers.

Markets. In middle-income countries, creative destruction is amplified by better connections between opportunity and entrepreneurship. Governments can help create and sustain contestable markets by weakening the forces of preservation, and they can work with investors and growth-oriented entrepreneurs to nurture infusion and innovation.