Middle-income trap: How can India avoid this future?

Context: 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.  The article suggests focusing on improving productivity and thereby the manufacturing sector to avoid the middle-income trap.
What is the middle-income trap and why it matters for India

• This trap was first conceived by World Bank economists.
• They 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. 
• There is little consensus on why some countries succeed in making the transition to high-income status.
• But a distinctive attribute of those that succeed in the transition to high income is productivity improvement.
• India could use its demographic dividend to avoid this predicament and achieve the critical velocity needed to move into the high-income bracket.

Ongoing Challenges

• First, disputes over land exert an enormous drag on the economy affecting investments worth USD 200 billion. Some 66% of civil cases in courts are tied to land and property. 
• Second, India’s air pollution crisis is severe and requires attention beyond current scattershot efforts. For example, it is estimated to reduce the life expectancy of a child born in India by 2.6 years — more than that in hotspots like north India.
• Third, water deserves to be high on the policy agenda; the Niti Aayog has warned that India’s water is in a crisis situation. Many states face acute water scarcity, water available per Indian declines every year, monsoons are becoming erratic, and water tables are falling even as we grow ever more dependent on groundwater.

How can India avoid the middle-income trap
1) Improve productivity

• 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 low 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.

2) Strengthen manufacturing sector

• Industrial labour relations is among the most critical elements to revitalize India’s manufacturing sector especially in the context of labour productivity.
• These labour laws created incentives for firms to remain small and uncompetitive, thereby affecting productivity.
• The new code, once implemented, would increase the threshold relating to layoffs and retrenchment in industrial establishments to 300 workers.
• 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.

3) Technology intensive manufacturing

• 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.
• 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.

Steps to improve 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%.

Road Ahead

• If India is to avoid a middle income environment trap, we have to get serious about land, air and water reform. 
• But there is an important caution. Reform should not be understood as an uncritical hacking away of legal and administrative safeguards, some of which are put in place to protect the poor and vulnerable who depend on natural resources for livelihood. 
• Instead, in all three cases, the underlying challenges are governance-related: ensuring availability of resources, without degrading their quality, and while safeguarding the interests of the poor.

We need appropriate interventions to improve productivity—both economy-wide and within the sector. And we must do it now.