ILLUSTRATION BY CHRISTIAN NORTHEAST
CONSIDER TWO paths for a software firm. In one, founded by former employees of a large conglomerate and financed from savings, it grows from a garage operation to a global leader, employing hundreds of thousands. In another, it starts small and stays small, trapped in informal work, never employing more than a handful. The first describes Infosys of India. The second describes the fate of most businesses in middle-income countries. Their economies display stasis rather than innovation: too few new firms disrupt and too few old ones evolve. Understanding why reveals a pattern of perverse incentives, protected incumbents and policy short-sightedness.
The standard model of growth, inspired by Joseph Schumpeter, imagines a gale of creative destruction where hungry entrants topple complacent incumbents. Reality in emerging markets is slower. Research from the World Bank shows firm life-cycles are flat. In America, a young firm grows sevenfold by age 40. In India, Mexico and Peru, the expansion is under threefold. American markets enforce a ruthless “up or out” logic. Middle-income countries prefer “flat and stay”. Most establishments are micro-enterprises that neither grow nor die, employing fewer than five people. They account for over 80% of firms in India and Mexico but add little to productivity gains.
This matters because productivity growth depends on moving capital and labour from laggards to leaders. When successful firms cannot expand, they cannot absorb resources from struggling ones. The engine of progress slows. The weakness has two roots: governments that unintentionally punish growth, and powerful incumbents that block it.
Policy is usually the first obstacle. Well-intentioned rules meant to protect small businesses or curb corporate concentration treat firm size as a measure of merit. The effect is to tax achievement. India’s Small-Scale Reservation Laws, in effect from the 1960s to the 2000s, decreed that hundreds of manufactured goods could be produced only by operations with minimal machinery. Expanding beyond a threshold was illegal. Similar distortions persist. In Peru firms with more than 21 workers must share profits with staff. In France companies crossing 50 employees face higher payroll levies and must form works councils. Such thresholds weigh heavily in entrepreneurs’ decisions. Why hire the 22nd worker if it triggers profit-sharing? Why reach 51 employees if it brings a host of new regulations?
These size-linked rules create what economists call “productivity-dependent distortions”. The most capable firms face the highest effective burden on expansion. Research by Chang-Tai Hsieh of the University of Chicago and Peter Klenow of Stanford University shows these distortions are far worse in middle-income countries than in advanced economies. The outcome is a misallocation of resources that depresses output. Compounding the effect, such rules weaken incentives to adopt better management practices or new technologies. Why invest in efficiency if growth brings penalties?
The second brake on growth comes from incumbents. Large, established firms can drive infusion, bringing global technologies and know-how to domestic markets. The Tata group’s creation of Tata Consultancy Services helped birth India’s software industry. Yet incumbents can also block. Where institutions are weak, dominant firms tend to defend positions through capture—of regulators, politicians and markets.
Consider telecommunications in Mexico. After a state monopoly ended in 1995, the sector stayed under the control of Telmex and Telcel for years. Their owner, Carlos Slim, became the world’s richest man. Only in 2014 did regulators finally impose obligations on firms with “significant market power”. In Italy research shows politically connected firms in local markets hire more local politicians and patent less. Their strategy shifts from competing on ideas to controlling the rules.
Market dominance itself is not the problem. It can reward real innovation. Trouble arises when it relies on government favour or anti-competitive tactics. In many middle-income countries, competition authorities lack resources or political support to police abuse. The practices are well-known: predatory pricing, exclusive contracts, strategic lawsuits and “killer acquisitions” meant to bury potential rivals. The result is slower innovation, higher prices as well as fewer consumer options.
State-owned enterprises add to the challenge. They benefit from cheaper capital and labour, tilting the playing field against more productive private rivals. In energy, 60% of low- and middle-income countries rely on public distribution utilities. SOEs accounted for half of fossil-fuel power investment from 2015 to 2019. Their presence limits private investment and slows adoption of cleaner technologies.
Escaping that trap demands a shift in policy thinking. The goal should be to encourage value creation rather than to protect firms of certain sizes. This calls for smarter rules. Modern Schumpeterian analysis offers tools. Instead of simply tracking investment or firm counts, governments should examine the micro-foundations of growth: rates of job creation and destruction; turnover among market leaders; spending on research and development; and patterns of technology licensing.
The forces of creation, preservation and destruction are always in tension. Middle-income countries have dampened destruction and preservation too much. They protect existing jobs and firms at the expense of future growth. The result is an economy stuck in low gear. Letting some firms fail, while others expand, is unsettling. Yet without that creative destruction, escaping the middle-income trap is impossible. Otherwise garage doors stay closed forever. ■
