Download Paper - NYU Center on US

What is the real Middle Income Trap and Why Inclusive and Balanced Growth is Important?
FAN Gang, NERI-China
And Yuwa Hedrick-Wong, Center for Inclusive Growth, MasterCard
The middle income trap is usually described as a sudden slowdown in economic growth in a
developing country when its per capita GDP approaches $4,000 (defined by the World Bank as
“middle income level”), and economic stagnation is the result of the being caught in the trap. The
standard explanation is that at this level of per capita GDP the country in question is becoming
“expensive” in labor cost compared to other lower income countries, and yet it is still unable to
compete with high income advanced countries due to an inadequate high tech sector, relatively
low productivity, and insufficient capacity for indigenous innovations. So at this middle level of
per capita GDP, the developing country is said to be “trapped” in a place where it is too expensive
compared with low income countries, and insufficiently competitive compared with high income
countries.
This formulation of the middle income trap, however, is problematic to say the least. To begin
with, the middle income level as defined means the so called middle income country is still a long
way behind the high income countries. It is self-evident that a country at $5,000 per capita GDP
cannot match the investment and level of development in education and scientific research, the
width and depth of the financial sector, and infrastructure for innovations in high income
countries with per capita GDP in the range of $40,000 to $50,000. Furthermore, progress in these
areas typically takes a long time; it may take a developing country up to 50 years to reach the
standards set by high income countries. There is simply no way for a developing country to
compete successfully head-on with technologically advanced high income countries on such a
basis. Setting up the middle income trap in such a way is tantamount to creating a self-fulfilling
prophecy – a developing country reaching the middle income level is bound to be trapped.
But such a division between high and low technology and productivity is completely arbitrary:
low tech at below $5,000 per capita GDP and high tech at $40,000 to $50,000 per capita GDP,
with nothing in between. We know this is not true. The technology spectrum is continuous, and
low tech manufacturing industries can progress gradually and continuously, one incremental step
at a time, to becoming more capital and knowledge intensive, with steadily rising productivity.
Similarly, innovations do not suddenly appear at $40,000 to $50,000 per capita GDP level and not
before. Innovations can happen at all levels of per capita GDP.
So from the perspective of a continuum as opposed to a break between middle and high incomes,
a developing country reaching middle level income supported by its middle level productivity
should face no middle income trap at all. As taught in introductory textbooks on economics, if the
marginal wage increase is equal to the marginal return to labor, then there is a state of
equilibrium. What then is the problem? The middle income developing country should be able to
continue to grow based on incremental improvement in technology and knowhow, leading to
gradual increase in productivity commensurate with its pace of wage increase. While there is no
“great leap forward” in technology and innovations capability, there can certainly be prospects
for reasonable and continuous growth. For example, Malaysia and Turkey are no longer low
income countries, but neither are they high income and high tech countries. They earn middle
and upper-middle level income based on their mid-level but steadily improving technologies; as
do many Eastern European countries.
The fact of the matter is that technology, education, financial institutions, and innovation
capacity are all “slow-moving variables” in economic development. They take a long time to gain
significant progress and to converge, if ever, with the advanced high income countries. In contrast,
variables like wage or household income can change much faster in the short run, especially
when there are policy interventions leading to income redistribution through taxation, social
welfare, fiscal subsidies, minimum wage requirement, etc. Thus, when there are concerns that
productivity growth lags income growth, the right question to ask may not be why productivity
growth is slow, but why income growth is higher than productivity growth. In this sense, the
middle income trap is connected with unsustainable income redistribution policies and/or
unaffordable welfare spending.
In many developing countries progress in technology and innovations suffers because of
institutional constraints such as government over-regulation, state-owned enterprise monopoly,
and financial underdevelopment. Sometimes, such constraints frequently lead to very slow
economic growth and even stagnation. But this is a challenge that can happen at any income
level, not just the middle income. For example, government over-regulation and state-owned
enterprise monopoly have been always the negative factors holding back China’s progress in
technology and innovation, even when China’s per capita GDP was only a fraction of what it is
now. Insufficient investment in education can also be a major negative factor holding back the
capacity for innovations in many countries, including some high income countries that earn
enormous revenues from exporting natural resources and energy. However, these factors are not
exclusive to countries in the “middle income” level. These are challenges that are more
appropriately labeled as “institutional trap” or “low education trap”, but not the “middle income
trap”.
With what has been said, is there something we can still describe as the middle income trap?
Indeed, there is.
The most striking phenomenon at the middle income stage of development is that income
disparity typically peaks compared with other stages. As a low income country develops through
more modern industries like labor intensive manufacturing, some segments of the population
start to benefit from better paid jobs in these industries, while the income of the remainder of
the population stuck in traditional industries and in agriculture remains unchanged and hence
poorer by comparison. This process creates a widening income gap, which typically gets worse as
the average (per capita) income gets higher. Only much later, when a significant portion of the
labor force has shifted from traditional industries and agriculture to more modern and productive
industries, and when workers suffering from under-employment in the rural sector become fully
employed in urban areas, then wages can increase at a faster pace for the whole of the labor
force (the “Lewis Turning Point” referred to in the economics literature). And in the post-Lewis
Turning Point period the income gap could start to close, as described by Simon Kuznet’s inverted
“U” curve.
The peaking of income gap usually brings about risks in rising social and political tension. Thus, a
developing country reaching the middle income level is also more vulnerable, compared to both
lower and higher income stages, to being affected by social and political crises that cause
economic slowdown and even stagnation, as can be readily observed in the recent development
histories of many developing countries. This can be construed as the real “trap” associated with
the middle income level.
This “true” middle income trap is fully sprung when governments and politicians in the middle
income countries react to the widening income gap with populist income redistribution policies.
Such policies trap these developing countries with problems of funding social welfare programs
that the government cannot yet afford; which over time could damage the economy’s
competitiveness, and may even lead to debt or financial crises down the road. For developing
countries just reaching the middle income level, the difficulty is that the “gold standard” of social
welfare is often seen as what is available in the high income countries. Opportunistic
governments and politicians in the developing countries are tempted to “catch up” with the high
income countries in promising generous social welfare spending, leading to runaway fiscal deficits;
thereby damaging the development prospects of the country. From this prospective, the middle
income trap is actually a “welfare catch-up trap” that is unique to developing countries at the
middle income level: high income countries can better afford the generous welfare programs
whereas low income countries are not pressed yet to offer such programs in response to a
widening income gap that is considered politically unacceptable.
So, in the middle income level, the deep cause for the frequently observed slowdown in
economic growth, or even stagnation, is the widening income gap that puts pressure on the
government to respond with unsustainable social welfare spending. The government finds itself
between a rock and a hard place: social and political unrest if it ignores the widening income gap,
or rising risks of debt and financial crises if it turns on the fiscal tap so wide that it drains its
feeble fiscal resources.
It is commonly believed that the solution to overcome the middle income trap lies in investing
more in education, improving institutions that support research and development, and expanding
indigenous capacity for innovations. But these are the kind of things any developing country
should do regardless of their specific stages of development. What developing countries should
focus on uniquely at the middle income level should be “inclusive and balanced growth”. The first
priority is to ensure that growth would entail a process of job creation that shifts more and more
low-income workers into higher income industries leading to an expanding and dynamic middle
class, which is the very meaning of inclusive growth. Simultaneously the social welfare system
should be made truly inclusive for the poor, while avoiding setting off an entitlement mentality in
the general public. In this context, inclusive growth can set in motion a virtuous circle: the higher
the portion of workers in better paid modern industries, the less fiscal spending is needed to
support those left behind; which in turn leaves the government with more spending power to
facilitate the growth of productivity enhancing factors. Meanwhile, a proper balance between
income redistribution and economic competitiveness should be painstakingly maintained to
avoid runaway fiscal deficits. It is only with such inclusive and balanced growth that a developing
country approaching the middle income level can avoid the true middle income traps – the
“welfare catch-up trap” and its associated social crisis.