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 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 was a 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 interre- sized productivity in a context in which developed countries lated and influence one another. 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 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 sustain- able 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 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 compo- nents: 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 spending on advanced technology products. Vietnam, which is Innovation Education 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. In another indicator of innovation, the annual average number of patent applications, Singapore significantly outper- formed the other five countries from 2011 to 2012, with 127.0 E ciency Infrastructure 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 Research & Policy Brief No.3 In an indicator of the performance of education systems, Figure 3. Mathematics Score in an International Assess- ment (PISA) versus GDP Per Capita scores on the recent PISA (Programme for International Student Assessment) test, Singapore had the highest math score of the six countries, Vietnam scored the second highest, followed by Chile, Malaysia, Mexico, and Peru (figure 3). Math score in PISA, 2012 Component 3: Efficiency Efficiency is defined as the effectiveness and timeliness with which capital and labor are allocated through the constant renewal of businesses across sectors. The key to efficiency is sectoral and corporate renewal and the flexible allocation and use of resources (Caballero and Hammour 1996; Hsieh and Klenow 2009). Structural transformation toward high value- added sectors from agriculture to industry and services has occurred in developed countries and is ongoing in developing countries (Divanbeigi, Paustian, and Loayza 2016). Corporate In (GDP per capita), 2014 renewal involves the death of inefficient companies, but also Source: OECD 2014. Note: PISA = Programme for International Student Assessment. the growth of productive companies and the emergence of CHL = Chile; MEX = Mexico; MYS = Malaysia; PER = Peru; new efficient ones. For this renewal to occur, flexibility of SGP = Singapore; VNM = Vietnam. resource allocation and use is critical; however, regulatory Component 2: Education rigidity has been an obstacle in many developing countries, impeding the adoption of new technologies and processes, Education develops human capacity by teaching knowledge the emergence of new enterprises, and the transition of and skills required for economic activities, disseminating and companies from informal to formal sectors. promoting existing technologies and processes that could lead to higher productivity in industries, and providing an From 1965 to 2014, a common feature among the six environment where new ideas are generated and developed countries was the decreasing share of total value added repre- into innovative technologies and processes (Nelson and sented by the agriculture sector and the increasing share of Phelps 1966; Gintis 1971). To increase productivity, countries service sectors (World Bank 2016). Nevertheless, the trajec- need a strong education system to provide primary and tory of the share of the industry sector varies across countries secondary education to everyone and promote higher educa- over the same period. The share increased in Mexico, Peru, tion and continuous training in university and industry. Malaysia, and Vietnam; remained stable in Chile; and decreased in Singapore, particularly since the mid-1980s. The comparison of indicators of education systems shows that Singapore scores the highest in all relevant factors includ- Indicators of the level of regulations on market, trade, and ing school enrollment, quality of primary education, adapt- labor show that Singapore has the lowest regulatory burden ability of higher education to economic needs, and company (figure 2, panel c). Malaysia is the second least regulated investment in staff training and development (figure 2, panel country, yet it imposes higher corporate taxation and trade b). Malaysia, ranked second, has a good primary education tariffs than Singapore. Chile ranks third; it has higher regula- system, a satisfactory level of adaptability of higher education tory burdens to start a business and more centralized regula- to economic needs, and a high level of company investment in tory control over companies’ hiring and firing practices than staff development; however, it has low secondary and tertiary Singapore and Malaysia. Peru ranks fourth, lagging behind school enrollment rates. Chile, the third ranked country, has a mainly due to high regulatory burden on starting a business, high enrollment rate for primary, secondary, and tertiary high corporate taxation, and highly centralized control over education; however, it lags behind in terms of the quality of companies’ hiring and firing practices. Mexico, which ranks primary education, adaptability of higher education to fifth, imposes particularly high corporate taxation and trade economic needs, and company investment in staff training. barriers. Vietnam is the most regulated country, with the Vietnam, Mexico, and Peru have high to moderate primary highest burden on starting a business and trade and high and secondary education enrollment; however, the quality of corporate taxation and trade tariffs. the primary and higher education system appears to be Regulatory burden and rigidity can have a negative impact unsatisfactory and company investment in staff training to be on goods and labor markets. Especially in developing countries insufficient. that lack transparent and effective governance, they may The equity in access to educational opportunities is result in high levels of informality because companies are another important measure of the quality of education discouraged from operating in formal sectors and instead run systems. A report by the Organisation for Economic their business outside a legal framework. Using as proxy for Co-operation and Development (OECD) indicates that the formal employment the fraction of the labor force that equity in the allocation of educational resources between contributes to a retirement pension fund, the share of socioeconomically advantaged and disadvantaged schools is informal employment in the labor force as of 2010 was less the highest in Singapore, followed by Malaysia, Vietnam, than 50 percent in Chile, Malaysia, and Singapore and more Chile, Mexico, and Peru (OECD 2014). than 75 percent in Mexico, Peru, and Vietnam. 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 sufficient national savings, debts at a manageable level, and a institutional infrastructure. 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. Bibliography Aghion, Philippe, and Peter Howitt. 2009. The Economics of Growth. Loayza, Norman, Pablo Fajnzylber, and César Calderón. 2005. Economic Cambridge, MA: MIT Press. Growth in Latin America and the Caribbean: Stylized Facts, Explanations, and Aschauer, David Alan. 1989. “Is Public Expenditure Productive?” Journal of Forecasts. Washington, DC: World Bank. Monetary Economics 23 (2): 177–200. https://openknowledge.worldbank.org/handle/10986/7315 License: CC BY 3.0 IGO. Barro, Robert, and Xavier Sala-i-Martin. 1995. Economic Growth. McGraw- Hill, Inc. Lucas, Robert. 1988. “On the Mechanics of Economic Development.” Journal of Monetary Economics 22 (1): 3–42. Caballero, Ricardo, and Mohamad Hammour. 1994. “The Cleansing Effect of Recessions.” American Economic Review 84 (5): 1350–68. Nelson, Richard R., and Edmund S. Phelps. 1966. “Investment in Humans, Technological Diffusion, and Economic Growth.” American Economic Review ---------. 1996. “On the Timing and Efficiency of Creative Destruction.” The 56 (1/2): 69–75. Quarterly Journal of Economics 111 (3): 805—52. OECD (Organisation for Economic Co-operation and Development). 2014. Easterly, William, and Ross Levine. 2001. “It’s Not Factor Accumulation: “PISA 2012 Results in Focus: What 15-year-olds Know and What They Can Do Stylized Facts and Growth Models.” The World Bank Economic Review 15 (2): with What They Know.” 177–219. http://www.oecd.org/pisa/keyfindings/pisa-2012-results-overview.pdf. Divanbeigi, Raian, Nina Paustian, and Norman Loayza. 2016. “Structural Pagés, Carmen, ed. 2010. The Age of Productivity: Transforming Economies Transformation of the Agricultural Sector: A Primer.” Research Policy Brief from the Bottom Up. New York: Palgrave Macmillan for the Inter-American No. 2, World Bank, Washington, DC. Development Bank. Fischer, Stanley. 1993. “The Role of Macroeconomic Factors in Growth.” Rivera-Batiz, Francisco L. 2002. “Democracy, Governance, and Economic Journal of Monetary Economics 32 (3): 485–512. Growth: Theory and Evidence.” Review of Development Economics 6 (2): Gintis, Herbert. 1971. “Education, Technology, and the Characteristics of 225–47. Worker Productivity.” American Economic Review 61 (2): 266–79. Scherer, Frederic M. 1986. Innovation and Growth: Schumpeterian Perspec- Hicks, John. 1939. Value and Capital. Oxford, United Kingdom: Clarendon tives. Cambridge, MA: MIT Press. Press. Schumpeter, Joseph. 1942. Capitalism, Socialism and Democracy. New York: Hsieh, Chang-Tai, and Peter J. Klenow. 2009. “Misallocation and Manufactur- Harper & Row. ing TFP in China and India.” The Quarterly Journal of Economics 124 (4): World Bank. 2016. World Development Indicators (database), World Bank, 1403–48. Washington, DC. Kraay, Aart. 2004. “When Is Growth Pro-Poor? Cross-Country Evidence.” World Economic Forum. 2015. The Global Competitiveness Report Working Paper WP/04/47, International Monetary Fund, Washington, DC. 2015–2016. Geneva: World Economic Forum. 4 Global Knowledge & Research Hub in Malaysia