Productivity As the Key to Economic Growth and Development

Research & Policy Briefs From the World Bank Malaysia Hub

No. 3, August 2016 Productivity as the Key to Economic Growth and Development Young Eun Kim, Norman Loayza, and Claudia Meza-Cuadra Without improvements in productivity, there is no economic growth—either sustained or inclusive. To raise productivity, four components must work together: innovation, education, eﬃciency, and infrastructure. Each requires contributions from the Public Disclosure Authorized public and private sectors.

The Central Role of Productivity education to spread these new technologies and develop the

capacity of the workforce; efficiency to promote the effective One of the most important lessons in economics is that and flexible allocation of resources for production in various productivity is key to economic growth. Productivity wasa sectors; and infrastructure, both physical (transports, energy main concern of the fathers of modern economics, Adam supply, and telecommunication systems) and intangible (public Smith and David Ricardo, in the eighteenth century, as they institutions and macroeconomic environment), to support considered the advantages of specialization and trade. In the twentieth century, John Hicks and Joseph Schumpeter empha- private activity (figure 1). These four components are interrelated and influence one another. sized productivity in a context in which developed countries were in the “Great Depression” (Hicks 1939; Schumpeter The rest of this Research Policy Brief discusses each compo- 1942). Recently, productivity has been a focus of economists nent and illustrates them by analyzing six countries in Asia and concerned about developing countries in their search for Latin America: Malaysia, Singapore, and Vietnam, and Chile, sustained growth. For example, a study based on a large

Public Disclosure Authorized Mexico, and Peru. These six countries are members of a free sample of countries by William Easterly and Ross Levine (2001) trade agreement recently signed on February 2016, the Trans- shows that economic growth is mainly explained by productiv- Pacific Partnership (TPP). ity growth. Our analysis across 132 countries also shows that the growth of GDP per capita at the global level is highly corre- Component 1: Innovation lated with the growth of productivity over the period 1960– 2014 (with a correlation coefficient of 0.86). Moreover, around Innovation consists of creating new technologies, new half the variance of GDP per capita across these countries for products, and new processes, which can potentially lead to the the same period is explained by the variance of productivity development of high value-added activities. Environments that (full results available upon request). promote innovation are characterized by sufficient and sustainable investment in research and development by both the What is Productivity? private and public sectors, a supply of competent scientists and engineers, high-quality research institutions, companies with Productivity is defined in economic theory as the ratio of the capacity to promote and support innovation, collaboration output over input. This translates into how efficiently input Public Disclosure Authorized between academics and industries, and the protection of resources such as capital and labor are used to produce intellectual property. economic output. Productivity is mainly driven by four components: innovation, including the creation of new technologies; A comparison of factors influencing innovation indicates that the countries with the most favorable environment are Figure 1. Main Components of Productivity Singapore and Malaysia (figure 2, panel a). Chile and Mexico rank third and fourth respectively, and the biggest gap between them and the first two countries exists in the level of company investment in research and development and government Innovation Education spending on advanced technology products. Vietnam, which is ranked fifth, has higher government spending on advanced technology products than Chile and Mexico, but scores lower in quality of scientific research institutes and university-industry collaboration in research and development. Peru, ranked last, Productivity scores lowest in most factors among the six countries.

Public Disclosure Authorized In another indicator of innovation, the annual average number of patent applications, Singapore signiﬁcantly outper- E ciency Infrastructure formed the other ﬁve countries from 2011 to 2012, with 127.0 applications per million people. Malaysia had 11.6 applications per million people, followed by Chile with 7.1, Mexico with 1.9, Peru with 0.3, and Vietnam with 0.2 (World Economic Forum 2015).

Aﬃliation: Development Research Group, the World Bank. Objective and disclaimer: Research & Policy Briefs synthesize existing research and data to shed light on a useful and interesting question for policy debate. Research & Policy Briefs carry the names of the authors and should be cited accordingly. The ﬁndings, interpretations, and conclusions are entirely those of the authors. They do not necessarily represent the views of the World Bank Group, its Executive Directors, or the governments they represent.

Global Knowledge & Research Hub in Malaysia Productivity as the Key to Economic Growth and Development

Figure 2. Indicators for the Main Components of Productivity in Selected TPP Countries

a. Innovation b. Educationa

Company Primary education spending on R&D enrollment (net %)

Government Secondary University-industry procurement Investment in staﬀ education collaboration of advanced training and enrollment in R&D technology development (gross %) products

Education meeting the Tertiary needs of a education Company Availability of competitive enrollment capacity for scientists and economy (gross %) innovation engineers

Quality of scientiﬁc Quality of primary education research institutions Score: 1 to 7 (best) Score: Original score (1-7) converted to 1 to 100 (best)

c. Eﬃciencyb d. Infrastructure, Physical

Procedures and days to Roads start a business

Company’s wage Corporate determination taxation Electricity supply Railroads

Hiring and ﬁring Trade barriers practices Air transport Ports Trade tariﬀs Score: 1 to 7 (least regulated) Score: 1 to 7 (best)

e. Infrastructure, Institutional

Intellectual property Selected TPP Countries: protection Chile Mexico Peru

Macroeconomic Transparency of Malaysia Singapore Vietnam stability government policymaking

Source: World Economic Forum 2015. Note: R&D = research and development. a. The definition of primary/secondary/tertiary education follows the International Standard Classification of Education (ISCED). Tertiary [Absence of] education includes ISCED level 5 (general and vocational) and level 6 Reliability of irregular (bachelor level, excluding master's and doctoral levels). Gross police services payments and enrollment includes students of all ages, including those enrolling bribes early or late, and/or repeating grades. Net enrollment includes only children of the official school age. [Absence of] wastefulness of government spending b. The number of procedures and days to start a business, corporate taxation, and trade tariffs were converted to a score between 1 and 7 by normalizing orginal data across 151 countries covered in the Score: 1 to 7 (best) survey.

2 h hget n igpr, olwd y aasa Vietnam, Malaysia, by Chile, Mexico, andPeru (OECD 2014). followed Singapore, in highest the is schools Economic disadvantaged between and advantaged resources socioeconomically educational for of allocation the Organisation that the in equity the indicates (OECD) Development by and is education Co-operation report opportunities of educational quality A to the systems. access of in measure important equity another The insufficient. to be appears system unsatisfactory education and company investment in staff training be to higher and primary the educationsecondary enrollment; and however, of quality the primary moderate to high have to Peru and Mexico, Vietnam, education training. staff of higher in investment company and needs, economic adaptability education, primary of tertiary quality the of terms and in behind lags however, secondary,education; it primary, for rate enrollment high school enrollment rates. Chile, the third ranked country, has a staff development; however, it has low secondary and tertiary to economic needs, and a high level of company investment in system, a satisfactory level of adaptability of education higher education primary good a has second, ranked Malaysia, b). panel 2, (figuredevelopment and stafftraininginvestment in company and needs, economic to education higher of ability adapt- education, primary of quality enrollment, school ing indicatorsthatof education comparison Theof systems Singapore shows scores the highest in all relevant factors includ tion and continuous training inuniversity andindustry. and primary provide to secondary education to everyone and system promote higher educa- education strong a need and (Nelson processes 1971). Gintis 1966; productivity, increase Phelps To countries and technologies innovative into an developed andgeneratedand providing are ideas new environmentwhere industries, in productivity higher that could to lead and processes technologies existing promoting and disseminating activities, economic forrequired skills and Education Component 2:Education SGP =Singapore; VNM=Vietnam. CHL =Chile;MEXMexico; MYS =Malaysia; PER=Peru; Note: Source: Math score in PISA, 2012 ment (PISA) versus GDPPer Capita Assess- an International in Score Mathematics 3. Figure PISA =Programme for International Student Assessment. OECD 2014. develops human capacity by teaching knowledge teaching by capacity human develops In (GDPpercapita), 2014 - aasa ad ita; eand tbe n hl; and Chile; in stable remained decreased inSingapore, particularly sincethemid-1980s. Vietnam; and Malaysia, Peru, Mexico, in increased share The period. same the over tory of the share of the industry sector varies across countries trajec- the Nevertheless, 2016). Bank (World sectors service of share increasing six the and the sector agriculture the among by sented feature common a 2014, to 1965 countries was From the decreasing share of total value added repre- of transition the and companies from informal to formal sectors. enterprises, new of emergence the processes, and technologies new of adoption the impeding countries, developing many in obstacle an been has regulatory however, rigidity is critical; use of and flexibility occur, allocation resource to renewal this For ones. efficient new of emergence the and companies productive of growth the also but companies, inefficient of death the involvesrenewal Corporate 2016). Loayza and Paustian, (Divanbeigi, countries developing in ongoing is and countriesdeveloped in occurred has services and industry to agriculture from sectors added value- high toward transformation Structural 2009). Klenow and Hsieh 1996; Hammour and (Caballero resources of use sectoralcorporateand renewal flexiblethe and allocation and is efficiency to key The sectors. across businesses constantof renewal the through allocated are labor and capital which with timeliness and effectiveness the as defined is Efficiency Component 3:Efficiency followed by Chile,Malaysia, Mexico, and Peru (figure 3). math International highest,second the scoredVietnam countries, highest six the of score for the had (Programme Singapore test, PISA Assessment) Student recent the systems, education of performance on the of indicator an scores In than 75percent inMexico, Peru, and Vietnam. more and Singapore and Malaysia, Chile, in of percent 50 than the share less was 2010 of as force labor the fund, that in employment informal pension force retirement labor a the to of contributes fraction the employment formal for proxy as Using framework. legal a outside business their are companies run instead because and sectors formal in operating discouragedfrom informality of levels may high they in governance, result effective and transparent lack that on negativegoodshave cana Regulatoryrigidity impact burdenand and labor markets. Especially in developing countries high and trade and corporate taxation and trade tariffs. a business starting the on with country, burden highest regulated most the is Vietnam barriers. andtrade taxation high corporate particularly imposes fifth, ranks which Mexico, practices. firing and hiring companies’ over control centralized highly and taxation, corporate high business, a starting on burden regulatory high behind to due mainly lagging fourth, ranks Peru Malaysia. and Singapore than practices firing and hiring companies’ over control tory centralizedregulamore- and business a start to burdens tory regula- higher has it third; ranks Chile Singapore. than tariffs trade and regulated taxation corporate least higher imposes second it the yet country, is Malaysia c). panel 2, (figure burden regulatory lowest the has Singapore that show labor Indicatorslevelregulationsthe of of market, on trade, and Research &Policy Brief No.3 3 Productivity as the Key to Economic Growth and Development

Component 4: Infrastructure lags behind the ﬁrst two in intellectual property protection and

efficient government spending. Vietnam, in fourth place, Infrastructure, both physical and intangible, is the fourth scores lower in all indicators when compared to the first three component promoting productivity (Aschauer 1989; Fischer countries. Peru, ranked fifth, has a highly stable macroeco- 1993; Rivera-Batiz 2002). Physical infrastructure includes trans- nomic environment, similar to the level of Singapore, but port, telecommunications, and energy supply systems; intan- scores low in other indicators. Mexico, ranked last, has a similar gible aspects include public institutions and the macroeco- level of performance to Vietnam in general, but with a lower nomic environment. Good public institutions are those that level of reliability of police services. protect the intellectual property of individuals and companies, make their policy decision making transparent, do not squan- Conclusion der their budgets, provide reliable public security to citizens and organizations, and maintain a stable macroeconomic Productivity is key for economic development, and is driven by environment. In turn, a stable macroeconomic environment is four interrelated components: innovation; education; characterized by a sustainable government budget balance, efficiency in allocation and use of resources; and physical and institutional infrastructure. sufficient national savings, debts at a manageable level, and a stable inflation rate with neither high inflation nor deflation. The investment needs and level of urgency for reform in The comparison of the quality of physical infrastructure in the four main components of productivity vary by country, terms of transportation and electricity supply shows that Singa- generally depending on the stage of economic development. pore and Malaysia have the first and second strongest Developed countries—because they are forerunners in infrastructure of the six countries, respectively (figure 2, panel technology and tend to have slower economic growth— d). Chile and Mexico lag behind these two mainly due to a low generally need to prioritize promoting innovation, while also quality of railroads. The physical infrastructure in Vietnam and alleviating the regulatory burden. Developing countries typically need to prioritize strengthening physical and institu- Peru is generally weak in all relevant indicators. tional infrastructure and primary and secondary education In a comparison of performance indicators of public systems. As the analysis of the six countries featured in this institutions—in terms of intellectual property protection, Research Policy Brief exemplifies, every country is in a differ- transparent policymaking, efficient government spending, ent stage of development and has its own strengths and weak- reliable police services, and macroeconomic stability— nesses in terms of the drivers of productivity. Governments Singapore and Malaysia again rank first and second, respec- may use this information to set their priorities and design tively, out of the six countries (figure 2, panel e). Chile, the third policies and programs to target these drivers, especially where ranked country, has highly reliable police services and a productivity gains depend on collective action and public relatively low level of irregular payments and bribes, but goods.

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