World Development Report 2024: The Middle-Income Trap

Economic growth is not a smooth process, and theory does not stipulate that it should be smooth. Instead, economic growth tends to be highly volatile, and long-run growth averages tend to mask periods of success, struggle, and failure. Growth in low- and middle-income countries is an “episodic” phenomenon, with countries experiencing distinct patterns of economic growth. In fact, a key characteristic of economic growth in middle-income countries is its lack of persistence. The volatility of growth rates is even higher in those countries, with sustained growth periods that are typically short-lived, even in countries that historically have enjoyed high growth rates (figure 1.3).

The standout economy—the growth superstar even—is the Republic of Korea, and this Report prominently features its experiences. What was behind its success? As subsequent chapters explain, Korea’s remarkable transformation from a postconflict country in the 1950s to an economy powered by the infusion of ideas from abroad to one that is transitioning to innovation at the global frontiers of technology makes its economic history required reading for policy makers in any middle-income country hoping to achieve high-income levels of living within their lifetimes (box 1.2; see chapter 2 for more information).

Growth slowdowns occur more frequently in middle-income countries than in low- or high-income countries (box 1.3). Research conducted for this Report uses a measure, proximity to the economic frontier (leading economies), to clarify the distribution of growth slowdowns along the national income spectrum around the world. The frontier represents the growth leader: the country with the most advanced combination of economic production, innovation, and workforce. For this analysis, the United States is used as a proxy for the frontier. Technically, a growth slowdown is defined as a break in the time series of the growth rate of GDP per capita, whereby the growth following the break is distinctly lower than the growth preceding it. Proximity to the frontier is the ratio of a country’s GDP per capita to that of the frontier country (the United States) each year (not adjusted for differences in PPP).

Box 1.2 A growth superstar: How the Republic of Korea leveraged foreign ideas and innovation

Over the last seven decades, Korea has engineered the most remarkable transformation in recorded economic history. It went from a war-torn, desperately poor country in the 1950s to one of the most prosperous, healthiest, and best-educated countries in the world today. With fewer than 50 million people, it is a global leader in innovation and technology and the tenth-largest economy. What was behind Korea’s success?

First, Korea prioritized openness through export promotion and leveraged the international markets to expose domestic firms to competition. Over time, it reduced tariff barriers and loosened restrictions on foreign investors to open the domestic market to foreign competition. It also promoted private enterprises through policies that first favored the growth and expansion of large conglomerates (efficiency-driven) and then shifted to favor smaller firms and entrepreneurs (equity-driven). Investments in infrastructure helped its rapid economic growth, with physical capital accounting for about 60 percent of growth in the gross domestic product (GDP) between 1990 and 1997. Early investments in information and communication technology infrastructure, amounting to US$32.5 billion between 1995 and 2005 and an additional US$2.6 billion between 2005 and 2014, enabled Korea to leverage new sources of growth driven by digital and technology adoption.

Second, Korea devised public policies to ensure contestability. The government rewarded firms for investments in research and development (R&D) and exports through R&D; it promoted science, technology, and innovation policies; it offered tax incentives; and it adopted export facilitation measures. Korea’s spending on R&D jumped from 0.5 percent of GDP in 1980 to 1.6 percent in 1990 when Korea was still an upper-middle-income country. Private R&D expenditures increased by an unprecedented 26 times from 1980 to 1990 and exceeded 80 percent of total R&D spending by the end of the 1990s. In parallel, Korea invested heavily in human capital and ensured that job creation was matched with the needed supply of skills at the different stages of development—vocational and technical secondary, STEM (science, technology, engineering, and mathematics) education, and R&D accelerators—which was carried out more effectively than by much richer countries.

Third, Korea got better at regulating the relationships among large, medium, and small firms. Initially, large firms were favored as the instrument for infusing new technologies into the economy. But by the mid-1990s the limits of this approach had become obvious, and yet powerful incumbents stymied the efforts of policy makers to change course. The 1997 Asian financial crisis changed the balance of power, and Korea established a new state–market relationship by adopting reforms to strengthen (1) financial market institutions with greater oversight and rules that diminished distortions; (2) competition policies that ended tacit government support for market collusion and concentration of market power; and (3) a pro-entrepreneurship policy regime with improved financing mechanisms for domestic technology ventures. The effectiveness of all of these policies was enhanced by stronger bureaucratic capacities, anticorruption initiatives, more transparent legal frameworks, better coordination mechanisms, and monitoring and evaluation systems.

Box 1.3 Identifying growth slowdowns

Several studies have examined the reasons for growth slowdowns. Eichengreen, Park, and Shin (2011) identify frequent slowdowns in middle-income countries. They define a slowdown as a decline in the seven-year average growth rate of gross domestic product (GDP) per capita by at least 2 percentage points, with growth being higher than 3.5 percent in the preceding years. In addition, they limit slowdowns to cases in which GDP per capita is greater than US$10,000 in 2005 constant international prices adjusted for purchasing power parity (PPP). They discover slowdowns when GDP per capita reaches about US$16,540 (in 2005 constant international PPP prices). Extensions of the analysis indicate that growth in middle-income countries slows even at points early in the middle-income stage: specifically, in the range of US$10,000–US$11,000 GDP per capita (in 2005 constant prices) and in the range of US$15,000–US$16,000 (in 2005 constant prices).

Eichengreen, Park, and Shin (2011) find that slowdowns are driven largely by low productivity growth. They also find that the probability of middle-income traps is higher in countries with high investment rates, high old-age dependency ratios,a and undervalued real exchange rates that translate into a barrier to move up the technology ladder. In addition, they find that the level and structure of human capital, the level and structure of exports (specifically, the relative importance of low- and high-tech exports), financial and political stability, and external shocks are among the significant correlates of slowdowns.

Aiyar et al. (2013) define the middle-income trap as a special case of growth slowdowns. They distinguish between natural slowdowns in growth and unusually severe slowdowns. Although economies in all income groups experience growth slowdowns, based on their analysis covering 1960–2005 middle-income countries are especially vulnerable to growth slowdowns. They point to steep drops in the growth of total factor productivity (TFP)b as a key driver of such slowdowns. Spence (2011) also finds slowdowns clustering in a narrow band of countries with income per capita of between US$5,000 and US$10,000.

Im and Rosenblatt (2013) focus on the probability of a country transitioning to the next income category. They find that the transition from upper-middle- to high-income status is just as likely as the transition from lower-middle- to upper-middle-income status. They argue that income per capita relative to the frontier stagnates after reaching middle--income status (for both lower-middle- and upper-middle-income countries). Their analysis suggests that it will take a century or more for middle-income countries to catch up to high-income countries if middle-income economies grow by 3–4 percent in per capita terms, assuming that the growth rate of high-income countries proceeds at the world average, which is 1.8 percent.

Robertson and Ye (2013) identify the middle-income trap as an ailment in which a country’s GDP per capita is time-invariantc and stays in the middle-income range, defined as between 8 percent and 36 -percent of GDP per capita of the United States.

a. The old-age dependency ratio is the ratio of older dependents (age 65 and over) to the working-age population (ages 15–64).

b. Total factor productivity, a concept created by Robert Solow, is an equation used in economics to measure the impact of technological advancements and changes in worker knowledge. It attempts to measure the effects that these changes have on the long-term output of an economic system.

c. A time-invariant variable refers to a variable whose value does not change across time.

Measured by their proximity to the frontier, the types of countries that experience growth slowdowns vary widely. When they enter a slowdown, their proximity to the frontier can range anywhere from just above 0 percent all the way to 150 percent. The median growth slowdown episode occurs in a country-year with just 11 percent proximity to the frontier, and the mean episode occurs at 21 percent proximity to the frontier—approximately the 75th percentile in the distribution. Together, these median and mean measures imply that a majority of growth slowdowns take place in middle-income countries (figure 1.4). In fact, a middle-income country is three times as likely to experience a growth slowdown compared with a high-income country.

Using the World Bank’s Long Term Growth Model (LTGM), figure 1.5 sheds more light on growth slowdowns in low- and middle-income countries. Assuming a “business as usual” baseline, where the growth drivers (ratios of public investment to GDP and private investment to GDP, total factor productivity, human capital, and labor force participation rates) follow their historical or recent trends, most low- and middle-income countries are forecasted to experience significant slowdowns as they approach the economic frontier country (the United States) over 2023–2100. In addition, middle-income countries whose growth has already significantly slowed, such as Argentina, Bulgaria, and Mexico, are expected to diverge from the economic frontier over the next 70 years. This is an unfortunate outcome because the key drivers of growth—savings, investment, productivity, human capital, and demographics—are already running out of steam.

Although researchers continue to debate the existence of a middle-income trap along the lines of that first flagged by the World Bank in the mid-2000s, policy makers in middle-income economies generally consider it a serious possibility. Their concerns are the motivation for this Report.

Developing countries should also seriously consider the close correlation between the quality of institutions and the probability of falling into the trap. Economists have conjectured that poor institutional quality discourages investment and innovation, distorts allocation, and lowers returns to entrepreneurship. And policy and institutional deficiencies can put the brakes on and even derail development. Research conducted for this Report reveals that countries with weaker political institutions—measured in many ways—experience growth slowdowns at lower levels of development than countries with stronger ones (figure 1.6). Panel a of figure 1.6 suggests that civil liberties may influence the overall conditions for investment, innovation, and growth. Countries with weaker economic freedoms also experience growth slowdowns while remaining far from the global frontier (figure 1.6, panel b). In other words, policy makers in middle-income countries should be mindful of the possibility that tighter economic restrictions may mean forgoing opportunities to close the gaps in living standards between their own economies and the more advanced economies in North America, Northeast Asia, Western Europe, and Oceania.