Escape the middle income trap; start planning now
PremiumWe must move right now to avert the ‘middle-income trap’ that India’s economy risks falling into once our demographic dividend of youth begins to wane some three decades hence.
India has a nearly 34-year window of opportunity to leverage its human resources and realize its growth potential before a phase of demographic burden sets in. This period will coincide with another important part of India’s growth story: the pursuit of high-income status. Too many countries have failed to make the leap from the middle-income to high-income group, afflicted by a malady now commonly referred to as ‘the middle-income trap’. This trap was first conceived by World Bank economists who found that of the 101 developing economies that could be classified as ‘middle income’ in 1960, only 13 managed to become rich nations by 2008. India could use its demographic dividend to avoid this predicament and achieve the critical velocity needed to move into the high-income bracket.
Improvement in productivity: There is little consensus on why some countries succeed in making the transition to high-income status, but a distinctive attribute of those that do is productivity improvement. Re-allocation of labour from low-productivity agriculture to high-productivity sectors, such as manufacturing, has been a primary channel through which today’s advanced economies raised their living standards.
In India, growth in labour productivity has consistently declined over the past decade. The annual growth rate of output per worker has dipped from 7.9% in 2010 to 3.5% in 2019, as per International Labour Organization estimates. This was also a period of frail growth in India’s manufacturing sector. In 2020-21, it accounted for only 14.5% of India’s gross value added, down from 17.4% in 2011-12. An essential first step in improving productivity would be strengthening this sector. With over 42.5% of the work force still engaged in agriculture, the move of workers from farms to factory jobs could be a source of economy-wide productivity growth. A mosaic of strategies are required to revitalize India’s manufacturing sector, of which industrial labour relations is among the most critical elements, especially in the context of labour productivity.
Labour laws in India are rigid, complex and archaic. Currently, industrial establishments try to employ less than 100 individuals to avoid falling under the purview of the Industrial Disputes Act, 1947, and factories keep their worker count below 20 (10 without power) to avoid coming under the Factories Act. As per the Annual Survey of Industries 2017-18, nearly 47% companies in India employed less than 20 workers. These labour laws created incentives for firms to remain small and uncompetitive, thereby affecting productivity. India has undertaken reforms to simplify the labyrinthine laws. The new code, once implemented, would increase the threshold relating to layoffs and retrenchment in industrial establishments to 300 workers. But individual and collective dismissals by companies above this threshold would still require prior permission of the appropriate government. Note that other countries, such as China, Vietnam and Bangladesh, with whom India competes for foreign investment and export markets do not require the approval of administrative or judicial bodies for dismissals. Therefore, in spite of recent reforms, India’s labour laws stay rigid in comparison with those of its competitor countries.
Technology-intensive manufacturing: India must also focus on improving ‘within sector’ productivity through, inter alia, research and development (R&D) investments, better management practices and adoption of new technologies. The experience of several countries that have fallen into the middle-income trap bears testimony to the need for a gradual strengthening of tech-intensive sectors. There comes a point for an economy in its development path when labour stops being cheap, requiring it to transform itself in some other way to continue its upward trajectory. Engendering innovation in higher value-added, tech-intensive activities is important for economies before they reach that juncture. If exports are taken as a proxy for the manufacturing capabilities and competitiveness of an economy, the present status of tech-intensive manufacturing in India leaves a lot to be desired. As per World Bank data, high-tech exports accounted for only 10.3% of India’s manufacturing exports in 2019, only a marginal improvement over its share of 9.7% in 2009 . Rival countries had a much higher share of the same: 31% in China, 13% in Brazil, 40% in Vietnam and 24% in Thailand. Low R&D spending in India, ranging from a mere 0.64% to 0.86% of gross domestic product over the past two decades, has held the country back.
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Recognizing the need for tech-intensive manufacturing, the government has introduced a production-linked incentive scheme to ensure a greater share of local value addition. While this would attract foreign investments in tech-intensive manufacturing, there is also a need for greater incentives for R&D investments by firms in India. A first step in this direction could be reinstating the tax exemption on R&D under Section 35 (2AB), even for companies opting for the lower corporate tax rate of 22%.
“Productivity isn’t everything, but in the long run, it is almost everything." This aphorism by Paul Krugman should be the guiding principle for the Indian growth story. We need appropriate interventions to improve productivity—both economy-wide and within sector. And we must do it now. After all, 34 years is a short period in the larger arc of a country’s economic history. These are the author’s personal views.
Jahanwi Singh is an economist with India Exim Bank
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