World Development Report 2024: The Middle-Income Trap

Middle-income countries are hampered by an imbalance among the forces of creation, preservation, and destruction. The forces of creation are weak, the forces of preservation are strong, and destruction is held back by the forces of preservation. Middle-income countries must therefore balance these forces (figure O.10). That means

• Disciplining incumbency to weaken the forces of preservation

• Rewarding merit activities—those with positive effects on general well-being and that aid in the efficient use of talent, capital, and energy—to strengthen the forces of creation

• Capitalizing on crises to aid the destruction of outdated policies and institutions that are difficult to dislodge during boom times.

These principles can help middle-income countries calibrate the mix of their three i’s—investment, infusion, and innovation—as they plan to accelerate economic growth. Because both incumbent firms and entrants can add value, industrial policies will need to focus on disciplining incumbency. And because the talent of women and disadvantaged groups is grossly underutilized, social policies will need to focus more on rewarding their merit and advancing social and economic mobility. And finally, because economic growth over the last three centuries has been emissions-intensive, middle-income countries will need to capitalize on today’s energy crisis to cut emissions while balancing energy access and security.

Enterprise, openness, and reforms

Countries growing out of low-income status into middle-income status tend to have a 1i strategy for accelerating investment. Stronger institutions are needed to control inflation, ensure financial and macroeconomic stability, expand economic and political freedoms, and enforce the rule of law to encourage both domestic and foreign investment. Even if all middle-income countries enjoyed such enabling conditions, a 1i strategy would not be enough to support sustained growth and move these countries out of the middle-income level. Why? The returns from capital investment alone decline steadily. Growth in middle-income countries is boosted when economies take on new structures, enabled by a 2i strategy focusing on both investment and infusion. Institutions will need to create an environment conducive to integrating global technologies into the domestic economy.

Make markets globally contestable

Contestable markets—and the institutions that enable them—are vital for middle-income countries that aim to become a global supplier and sustain rapid economic growth through sophistication and scale.

Contestability is not chaos: it does not mean that firms in middle-income countries cannot earn comfortable market positions, becoming established and relatively difficult to displace. However, contestability does mean that firms feel pressure to compete because their current products and processes can be displaced by technologically sophisticated producers from other countries. Such contestability is central to creative destruction.

A key part of contestability is openness to foreign investors and global value chains that give domestic firms access to larger markets, technology, and know-how and allows them to add value and grow. And they are encouraged to make use of that access, thereby exposing domestic firms to competition, but also inspiration, from international firms that operate at or near the global technology frontier. Firms at home can seize the opportunity to infuse technology, increase the sophistication of their operations, and scale up, or they can keep doing business as usual and be eased out.

For example, in Chile imports of Chinese products rose at an average pace of 27 percent a year from 2001 to 2007, and large Chilean incumbent firms, or market leaders, boosted their product innovation by 15 percent and their product quality by 22 percent. In Argentina, after MERCOSUR (Southern Common Market) was established, domestic firms in sectors facing export tariff reductions began to invest more in computing technology and in technology transfers and patents. Again, in 12 European countries over 2000–2007 more than 15 percent of the increase in patenting, information technology intensity, and productivity was driven by import competition from China—and successful European firms boosted management quality while increasing research and development (R&D) and adding new skills.

Connect local firms with market leaders

Because local firms often do not have information on specific technologies and the know-how to adopt them, consultants and advisory firms founded by experts can provide expertise and advice on technology adoption and implementation. Market leaders—especially multinationals—are often vanguards in technology and technical capabilities and can be some of the best partners for local firms, working together to deploy new technologies. The government can help make the relevant connections. For example, in Chile the Supplier Development Program, which offers large domestic buying firms an incentive to connect with suppliers that are SMEs, increased the suppliers’ sales by 16 percent and their employment by 8 percent. It also boosted the sales of large sponsor firms by 19 percent. Governments can also provide firms with information on market opportunities, enabling them to access finance and strengthen their capabilities, as well as to recognize opportunity and mobilize themselves to take advantage of it.

Reduce factor and product market regulations

Reforms that roll back protection for specific activities, enterprises, families, or industries reinforce the gains from openness. However, today middle-income countries are slow to combine investment with infusion and innovation, stymied by the powerful institutional and regulatory forces of preservation. Especially binding are product market regulations. Besides imposing constraints on international trade and investment, these regulations prop up state control of business and impose legal and administrative barriers to entrepreneurship, thereby hobbling investment and infusion at scale.

Move away from coddling small firms or vilifying large firms

Small and medium-size enterprises are widespread in middle-income countries. Ideally, subsidies would help SMEs grow into larger, more productive companies that pay higher wages and adapt knowledge. But the same support also strengthens the forces of preservation by reducing 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 countries that include Japan, Mexico, and Viet Nam, public support for small firms—not necessarily young firms—reduced productivity and increased resource misallocation.

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—that is, governments with weak tax collection capacity may concentrate enforcement on larger firms. 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.

Let go of unproductive firms

Letting inefficient firms and business models fail is a core principle of creative destruction. Studies of firm exit—stemming from seminal work by Hopenhayn (1992)—have revealed 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 of bankruptcy laws should focus on enabling failed businesses to exit swiftly and predictably and on allowing viable businesses to restructure.

Strengthen competition agencies

As segments of an economy master infusion, they will need to adopt a 3i strategy. Institutions can foster the development of new technologies and ensure that entrants—new entrepreneurs—are not blocked by established incumbents, regulatory barriers, and entrenched industry practices. Antitrust laws can help prevent abuse of dominance by established incumbents. As economies (or sectors) move closer to the technology frontier, competition agencies will need to consider a possible trade-off between innovation incentives and market power. Although market power enables investment in R&D to bring new ideas to market, firms may resort to anticompetitive behavior. Thus, competition and innovation policies need coordination, alongside developing independent, capable competition authorities.

For upper-middle-income countries shifting to a 3i strategy, a special concern is the containment of killer acquisitions—that is, when incumbents acquire innovative firms specifically to kill future competing products and technologies. But not all acquisitions are deadly: many young entrepreneurs make a deliberate effort to be acquired by an incumbent, producing complementary innovations that an incumbent can scale up.