New Delhi: It will take India 75 more years to reach a per capita income level that is even one-quarter the size of what it is in the US today, says a new World Bank report.
The reasons for this, it pointed out, had to do with several factors, including the preponderance of small firms in India, the inability of larger ones to grow rapidly, the role of government regulation in ensuring this remains the case, and, to some extent, the state of the global economy.
The World Bank’s World Development Report 2024 titled ‘The Middle Income Trap’, that was released Friday morning (IST) in Washington, said that India — as a lower middle-income country — would need to tweak its policies to encourage the infusion of expertise from abroad in addition to focussing on investment-led growth.
“The road ahead has even stiffer challenges than those seen in the past: rapidly ageing populations and burgeoning debt, fierce geopolitical and trade frictions, and the growing difficulty of speeding up economic progress without fouling the environment,” the report said.
“Yet, many middle-income countries still use a playbook from the last century, relying mainly on policies designed to expand investment,” it added. “If they stick with the old playbook, most developing countries will lose the race to create reasonably prosperous societies by the middle of this century.”
According to the World Bank, at current trends, it will take China more than 10 years to reach one-quarter of US income per capita, Indonesia nearly 70 years, and India 75 years.
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Moving beyond ‘flat and stay’
According to the report, if a firm in India, Mexico, or Peru operates for 40 years, it will roughly double in size, whereas the same firm in the US would grow sevenfold in the same period. “For firms in middle-income countries, this implies a ‘flat and stay’ dynamic: firms that fail to grow substantially can still survive for decades,” it said. “By contrast, for US firms the dynamic is ‘up or out’: facing intense competitive pressure, a few entrepreneurs will expand their businesses rapidly, while most others will exit quickly. Among the majority who exit the market, many will become wage earners at the most flourishing firms.”
The report further highlighted that, in keeping with the ‘flat and stay’ dynamic, firms in India, Mexico, and Peru tend to remain micro-enterprises with almost 90 percent of firms employing fewer than five employees, and only a “tiny minority” with 10 or more employees.
“The longevity of undersized firms—many of them informal—points to market distortions that keep enterprises small while keeping too many in business,” the report noted. “For example, a high regulatory cost attached to formal business growth may inhibit an efficient firm from gaining market share and driving out inefficient competitors.”
These policy-induced distortions in middle-income countries result in misallocated resources and the hampering of creation and innovation, it added.
The downside of focussing attention on small firms
The analysis also talked about how, in middle-income countries like India, subsidies would ideally help small companies grow into larger, more productive ones that could 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,” it added. “Many firms in middle-income countries remain small even when long established; they simply do not aspire to grow.”
“Blanket support for small firms can curtail the exit of unproductive small businesses, perpetuate smallness, crowd out other firms, and misallocate resources,” it said.
The other reason why small firms tend to not grow, the report said, is to do with human nature. It said that an inability to trust people and institutions beyond one’s own family and social network could limit the growth of firms and their productivity levels.
“In developing countries, firm owners generally make major management decisions themselves because they fear the consequences of delegating to their managers,” it said. “But because their time and talent are limited, owners are compelled to manage firms through their children. In India, for example, this factor underlies firms’ inability to grow.”
In fact, the report estimated that the impact of this factor could be quite significant, with a poor delegation of managerial responsibilities possibly accounting for 11 percent of the difference in income per capita between India and the US.
The need to make big firms better
Notably, the report also said that the large number of small firms in middle-income countries was not just a result of them remaining small, but also of larger firms not being able to grow or innovate enough to displace these smaller companies.
“To support innovation, countries will have to find ways to make existing firms (incumbents) — both industrial conglomerates and economic elites — innovative and more productive and to make way for newcomers,” it said.
While it highlighted a few success stories in India and China, such as Infosys and Alibaba, it also said that too many markets are “hobbled by excessive business regulations, government patronage, and limited international competition”.
“In such an environment, powerful owners and unproductive large firms can stifle growth, lobbying to protect their preferential access and monopoly rents when they could instead be investing in productivity-enhancing technology,” the report said.
The analysis found that, while the share of small firms with a maximum of four workers declines by 60 percent by the time these firms are 25 years old in the US, this decrease is only about 10 percent in India.
“Consequently, the Indian economy lacks the mechanism for effective selection among firms, hindering the reallocation of resources to more productive users,” it said.
How to rise up the ladder
In order to rapidly increase per capita income levels, the World Bank said middle-income countries will have to become more disciplined.
“They will have to time the shift from simpler investment-led growth strategies that worked well in the early stages of development to augmenting investment accelerations with intentional policies that aid the infusion of knowhow from abroad, and only then expend sizeable resources on innovation,” it said.
“Put another way, they will have to become more efficient in their use of capital — both financial and human — and labour and energy,” it added.
It said that low-income countries can focus solely on policies designed to increase investment, but, once they attain lower-middle-income status — as India did in 2007 — they will need to shift gears and expand the policy mix to investment plus an infusion of knowledge from abroad.
“Middle-income countries will need progressively greater economic freedom, more open and informed debates, and — frequently — the political courage to change stubborn institutions and long-standing arrangements,” it said.
A balanced tax policy
While a progressive income tax system can reduce inequality, tax rates that are too high can dampen incentives to undertake high-return, high-risk innovation activities, the report noted.
“For example, in response to higher income taxes, innovators or entrepreneurs can reduce their efforts, evade taxes, or migrate to lower-tax localities,” it said. “Inventors prefer to locate in the same places as other inventors in their specific domain.”
One of the solutions the World Bank suggested was for middle-income countries to use inheritance or estate taxes — controversially suggested by former Congress member Sam Pitroda in the run-up to general elections 2024 — to reduce wealth inequality while financing social protection programmes.
Such taxes, implemented progressively, can “motivate charitable giving by allowing tax deductions for donations by wealthy individuals—and others—just as progressive income taxes often do”.
“What is critical is finding the optimal tax rate that will balance disincentive effects with steps to lower inequality,” the report said. “Governments can also offset some of the disincentive effects of progressive taxation by supporting an enabling innovation environment, with universities, high-quality infrastructure, urban amenities, and direct incentives for innovation (R&D subsidies).”
(Edited by Sanya Mathur)
There should be a sense of realism in talking about India becoming a developed country by 2047.