Middle Income Trap, Key Factors and Challenges for India

Only 34 middle-income nations advanced to high-income status in 34 years as per World Development Report 2024. Check here Key Factors Contributing to the Middle-Income Trap.

Table of Contents

Middle Income Trap

The middle-income trap is a situation where a country that attains a certain income gets stuck at that middle-income level and is unable to transition to a high-income level.

The World Bank defines middle-income economies as those with incomes between $1,136 and $13,845 per capita.

The middle-income trap refers to the stagnation of income per capita when economies reach about 11% of U.S. per capita income levels.

Key Factors Contributing to the Middle-Income Trap

Diminishing Returns to Capital: As countries grow, the returns on additional investments in physical capital tend to decline, making it harder to sustain high growth rates.
Exhaustion of Cheap Labour: The initial advantages of low labour costs diminish as wages rise, leading to increased unit labour costs that can hinder competitiveness.
Premature Deindustrialization: Many middle-income countries experience a decline in manufacturing at lower income levels than before, limiting their ability to drive growth through industrialization.
Insufficient Quality of Human Capital: A lack of skilled labour can impede innovation and productivity growth.
Failure to Invest in Education and Training: Early growth often relies on labour-intensive industries rather than productivity-driven sectors, leading to a skills mismatch in the economy.
Weak Institutions: Ineffective governance and institutions may not support an adaptive economy capable of fostering innovation and competition.
Misallocation of Resources: Distorted incentives can lead to talent misallocation, where individuals are not employed in roles that maximise their potential contributions to the economy.
Inflation and Credit Bubbles: High inflation rates and speculative investments can destabilise economies, making it difficult for them to maintain growth momentum.
Lack of Access to Finance: Limited access to venture capital and advanced financial instruments can stifle innovation and entrepreneurship.
Increased Competition: Middle-income countries often find themselves squeezed between low-wage competitors from poorer nations and high-tech innovators from wealthier countries.
Trade Frictions and Geopolitical Tensions: Current global economic uncertainties add further burdens on middle-income economies, complicating their ability to compete internationally.

Key Highlights of the World Development Report 2024

Middle Income Trap:

India is among 100 countries, including China, at risk of falling into the “middle-income trap,” where nations struggle to move from middle-income to high-income status.
India stands at a crucial point, benefiting from favourable demographics and digitalization advancements but faces a more challenging global environment compared to earlier periods.
Achieving the goal of becoming a developed nation by 2047 will require a holistic approach that boosts overall economic performance, rather than focusing on specific sectors.
Since 1990, only 34 middle-income economies have transitioned to high-income status, often due to special circumstances like EU integration or oil reserves.
Middle-income countries face growth challenges due to diminishing returns on physical capital, unlike low-income countries that benefit from building physical infrastructure and improving basic education.
Countries like India in the 1980s saw growth through capital deepening, but middle-income economies now face diminishing returns as they invest further.
Simply raising savings and investment rates isn’t enough to sustain growth in these economies; factors beyond physical capital need addressing.
Despite relatively high capital endowments, middle-income countries struggle with productivity, showing that physical capital alone isn’t the main obstacle to growth.
The World Bank criticises many middle-income countries for relying on outdated economic strategies that emphasise expanding investment.

Global Economic Impact:

Middle-income countries are home to six billion people, representing 75% of the world’s population, and contribute over 40% of global GDP.
The success or failure of these nations in reaching high-income status will have a substantial effect on global economic prosperity.

Per Capita Income Disparity:

Although India is the fastest-growing major economy, it would take 75 years to reach just one-quarter of the U.S. per capita income if current trends persist.
China is projected to take over 10 years, Indonesia nearly 70 years, and India 75 years to achieve a quarter of U.S. per capita income levels.

Challenges and Risks:

Middle-income countries face major challenges including ageing populations, increasing debt, geopolitical tensions, trade frictions, and environmental concerns.
If these nations continue on their current trajectories, they risk failing to achieve reasonably prosperous societies by the mid-21st century.

Challenges for India

Wealth Concentration and Inequality

The influence of billionaires in India’s economy has grown significantly, and there is a perception that they are closely aligned with political power.
The state is seen as unable (or unwilling) to push for high rates of domestic investment from these billionaires.
The manufacturing sector has stagnated, and India is experiencing a reversal in structural transformation, with a growing share of the population returning to low-productivity agriculture post-pandemic.

Wage Growth Discrepancy

Despite India’s projected real GDP growth of around 7%, nominal wage growth has lagged behind.
The Periodic Labour Force Survey (PLFS) indicates that nominal wages for regular workers grew by only 5% between April and June 2023-24, and for casual workers, by 7%.
With inflation at 5%, wage earners have seen minimal to no real wage growth, hindering broader participation in the economy’s growth.
A lack of wage growth limits consumption demand, which in turn, slows down overall economic progress.

Democracy and Growth

Both South Korea and Chile had authoritarian governments when they transitioned to high-income economies.
South Korea’s military government suppressed labour unions to promote capital accumulation, and Chile’s democratic government was overthrown in favour of a military dictatorship led by General Augusto Pinochet.
India must not adopt the wrong lessons from these countries by compromising democracy in pursuit of economic growth.
Policy must focus on maintaining a democratic ethos while promoting growth through state intervention.

Way Forward

The 3i Approach: The World Development Report 2024 emphasises a three-pronged strategy known as the “3i” approach:
- Investment: Increasing capital investments in various sectors.
- Infusion: Ensuring the adoption of new global technologies.
- Innovation: Creating an environment conducive to domestic innovation.
- These strategies require responsive state policies to navigate modern economic challenges effectively
Pursue Liberal Economic Policies: Focus on policies that support private sector growth and entrepreneurship.
Develop Low-Skilled Manufacturing: Encourage sectors like electronics assembly and apparel to create jobs and boost exports.
- Example: South Korea and Taiwan’s success through export-oriented manufacturing.
Build Industrial Clusters: Develop clusters with plug-and-play infrastructure, similar to China and Vietnam.
- Address cost disabilities in power, logistics, financing, and labour productivity.
Enhance Female Labor Force Participation: Implement policies to increase FLFPR to levels seen in other rapidly growing economies.
Avoid Protectionist Policies: Resist high import tariffs to prevent inefficiencies and maintain competitiveness in exports.
- Example: Impact of tariffs on mobile phone manufacturing.
Minimum Government, Maximum Governance: Reduce bureaucratic red tape and improve ease of doing business to encourage private investment.