## ipgdcfea ## Source details **Canonical URL:** [ipgdcfea](https://www.imf.org/-/media/files/publications/dp/2022/english/ipgdcfea.pdf) ## Other formats - [Markdown version](/-/media/files/publications/dp/2022/english/ipgdcfea.pdf.md) - [Structured JSON version](/-/media/files/publications/dp/2022/english/ipgdcfea.pdf.json) --- ### Executive summary — key points - As countries recover from the COVID-19 pandemic they need to map a new path for development that promotes diversification, develops new industrial capabilities, and designs policies to achieve high and sustained growth. - A successful diversification strategy should tackle both broad policy failures (unfavorable business environment and investment climate) and sector-specific market failures. - This departmental paper presents a conceptual framework to analyze industrial policy, defined as targeted sectoral interventions. - Four guiding principles for policymakers: - Focus on the nature and magnitude of market failures that could justify targeted sectoral interventions. - Subject interventions to a cost-benefit test. - Analyze potential government failures (weak governance, limited administrative capacity). - Consider how to mitigate risks associated with weak governance. - The paper discusses commonly employed policy tools, their rationale, and associated pitfalls, and outlines a stylized decision-making framework. ### Introduction — contextual findings - Economic diversification is central to structural transformation and development; sustained growth and improved living standards are associated with diversification (IMF 2014). - Diversification involves transition from agriculture or mining toward a wider range of sectors, more sophisticated products, and higher-quality varieties of goods and services. - Drivers include infrastructure, education, fiscal and monetary policies, technology, and social development. - The COVID-19 pandemic highlighted vulnerabilities of countries lacking industrial capabilities (shortages of vaccines, tests, and medical goods). - Climate change (IMF 2020) and rising automation heighten the need for renewed diversification efforts. ### Guiding Principles: Market Failures versus Government Failures - Industrial policy is typically justified by sector-specific externalities where benefits of addressing them outweigh costs and risks of intervention. - Conditions for welfare-enhancing targeted intervention: - The intervention must address an externality. - The externality must not be resolvable through neutral means (e.g., better property rights). - The intervention must pass a cost-benefit test considering alternative public-fund uses. - Government failures must not undermine the intervention’s case. #### A. Externalities and sector selection — findings - Coordination failures and learning externalities imply firms may not internalize productivity gains; new sectors may need critical scale and scope requiring coordinated action (Murphy, Shleifer, and Vishny 1989). - Supply of specialized intermediate goods, skills, or infrastructure may be absent because suppliers lack incentives to enter an undeveloped sector. - Knowledge spillovers can boost productivity in other firms or sectors; policy promoting sectoral clusters may enable productivity gains (“economies of agglomeration”). - Learning externalities: firms bear discovery risk; successful entrants create information others can use, leading to potential under-entry or too little “self-discovery.” (Hausmann and Rodrik 2003). - Information frictions in export markets may impede reputation-building (Atkin, Khandelwal, and Osman 2017). - Externalities argument for intervention is strongest in modern, tradable sectors, especially those with: - High R&D intensity and relative sophistication. - Manufacturing characteristics: high productivity growth and potential convergence to world frontier. - Modern services (transport and communications, financial intermediation, business services) showing increasing sophistication, tradability, scale, innovation, and learning-by-doing; AI and blockchain may further enhance productivity and spillovers. - Emerging industries with similar characteristics: clean tech (renewable energy, electric vehicles, and batteries), robotics, and 3D printing. - Modern agri-business (e.g., salmon farming) may also feature significant knowledge spillovers. - Sector distribution reflects exogenous factors (geography, climate) via transport costs and access to inputs/markets. - Short-term “quick win” sectors (traditional services, agricultural processing, textiles, tourism, call centers) require less state intervention and can employ many workers and generate resources for advanced sectors, but exclusive focus on them risks missing transformative technology and innovation-led growth. #### B. Cost-benefit test — guidance and findings - Active policy must pass an appropriate cost-benefit test. - Costs include invested amounts plus administrative and efficiency costs of raising tax revenue (especially high in developing countries). - Benefits equal the difference in value added between the project and counterfactual uses of labor and capital (unless those resources would have remained unemployed). - Benefits should include spillovers, learning-by-doing, and social value of reduced volatility. - Distributional/social implications matter: will the project open opportunities or mainly transfer funds to a few beneficiaries? - Cost-benefit analysis is difficult: costs easier to assess; benefits uncertain and future-dated. Still useful as a first-approximation if risks and opportunities are appropriately weighted. - Social rate of return should exceed best alternative return to funds, including returning money to taxpayers or intervening in sectors with greater spillovers. - Some externalities may be resolved through property-rights assignment (e.g., auctioning the right to construct coordinated assets), but this can create monopoly risks and presumes regulatory capacity. - Such solutions may be less appropriate where coordination involves many actors with specialized capabilities. #### C. Government failure: incentives and information — risks - Government actors respond to incentives like private actors; risks include: - Rent-seeking, corruption, mercantilist pressures, and capture by special interests — amplified in weak institutional environments. - Legislators directing funds to their districts regardless of social optimality. - Agencies competing for influence and seeking program continuation irrespective of social contribution. - Citizens face costs to monitor program effectiveness; monitoring and accountability may be weak. - Consequences: - Governments may alter programs, misuse opportunities (e.g., SEZs used for land appropriation for real-estate), announce policies for electoral gains without implementation, or fail to implement exit strategies (infant-industry protection is hard to withdraw). - Informational requirements for rigorous evaluation are high; some information is unobtainable. Incentive issues may deter transparent monitoring and evaluation, amplifying distorted outcomes and unintended consequences. #### D. Designing policy to mitigate risks — recommendations - Principles to minimize government-failure risk: - Demand accountability for support received via specific performance targets (e.g., export market shares) and willingness to cut losses. - Maintain competition: support sectors rather than firms; focus on export orientation (contrasted with import-substitution and high-tariff approaches). - Use independent, appropriately qualified experts to select projects for public support. - Complement interventions with reforms to control corruption. - Avoid overly strict accountability that paralyzes action—some unavoidable risks remain. - Strategies to reduce informational uncertainty: - Analyze how much money is at risk if uncertain benefits fail to materialize (costs easier to establish than benefits). - Pre-screen proposals with back-of-the-envelope calculations to check likelihood of meeting cost-benefit standards. - Require interventions to bear the burden of proving merits; involve the private sector from the outset to incentivize data generation. - Invest in information gathering to assess net benefits, benchmark costs internationally, and evaluate past programs after conclusion. - Pilot policy proposals on small scale to test feasibility, costs, and benefits before scaling up. ### 3. Policy Tools — overview and key guidance - Taxonomy: five categories of instruments considered are (1) product market, (2) capital market, (3) labor market, (4) land market, and (5) technology. - Decision-making heuristic: choose tools that address identified market failures, pass the cost-benefit test, and are designed to limit government-failure risks through accountability, competition, and time-limited support. ### 3.A Product Market — instruments, evidence, and governance - Trade Policy - Instruments: import tariffs and nontariff barriers, including import quotas, local content requirements, and export subsidies; differential tax rates for profits from export sales; import-tariff rebates on imported intermediates; credit lines for exports; subsidies to foreign investors on the purchase of domestic inputs. - Constraints: global trading regime restricts many instruments; alternative tools should ensure consistency with World Trade Organization (WTO) rules. - Evidence and risks: - Industry case studies find that protection often led to net welfare losses. - Tariffs on capital and intermediate goods are especially likely to reduce growth. - Protection of skill-intensive sectors is more likely to be associated with faster growth, at least in countries with good governance. - Tax Incentives to Promote Investment - Instruments: tax holidays and exemptions, special corporate tax structures, targeted allowances, subsidized infrastructure, accelerated depreciation schemes, investment tax credits, super deductions, profit-based tax holidays. - Evidence and risks: - Tax incentives can significantly erode revenues without achieving offsetting benefits unless properly designed and time-bound. - Well-targeted incentives reducing the cost of capital have had some success in advanced economies; open-ended and profit-based tax holidays are less effective and can erode the tax base indefinitely. - Tax incentives commonly used to attract FDI are often found to be largely ineffective, with their costs exceeding any spillovers. - Complementary inputs and policies needed: macroeconomic stability, a minimum level of human capital, high-quality infrastructure, openness to trade, developed financial markets, non-stringent capital controls, attractive business environment including strong property rights and efficient regulation. - Governance recommendation: tax incentives should be governed by tax laws with minimum discretion; beneficiaries should file returns even where no tax obligation exists to measure costs and outcomes. - The State as a Producer and Consumer - Roles: state participation via state-owned enterprises (SOEs) and through public procurement. - Risks and benefits: - Direct involvement often proven costly with hidden subsidies, direct transfers, and overstaffing; SOEs tend to crowd out private investment. - SOEs can generate positive human capital and R&D spillovers (example: technological externalities from Airbus). - Governance recommendation: clear mandates, strong governance rules, high transparency, appropriate manager incentives, effective oversight and risk mitigation. - Measures to Reduce Informational Frictions - Instruments: promotion agencies that match buyers with suppliers; export promotion agencies organizing fairs, linkage programs, quality certification schemes; “soft industrial policy.” - Effectiveness: likely to boost exports when providing a clear and effective one-stop shop; fragmented agencies with unclear mandates are less effective. ### 3.B Capital Market — instruments, evidence, and risks - Rationale: financing to enter new sectors is difficult where financial sector is underdeveloped, prudential restrictions shorten investment horizons, and collateral is hard to establish; public sector may have longer horizons or better information. - Directed and Direct Lending - Instruments: instruct commercial banks to allocate lending to particular sectors; public sector lending via specialized development banks or export-import banks. - Evidence and risks: - Directed lending can boost production when firms are severely credit constrained but can undermine financial sector profitability. - Public lending increases public borrowing requirement; subsidized interest rates amount to fiscal subsidies. - Large-scale failures of development banks in the 1970s and 1980s led many to be privatized or closed. - Development banks often face large nonperforming loans and lack well-defined development mandates; may crowd out private intermediaries. - Credit Guarantees - Instruments: government loan guarantees to support credit flows from commercial banks or investors. - Recent use: expanded considerably in the wake of the COVID-19 pandemic. - Risks and evidence: - Guarantees create contingent liabilities for the public sector; beneficiaries may misuse funds. - Improper use can adversely affect public financial management and fiscal policy. - Few rigorous evaluations; difficult to identify schemes that resulted in appreciable increases in lending; several have suffered significant losses. - Venture Capital and Incubators - Instruments: public intervention to develop venture capital/private equity sectors; public bodies acting as venture capital firms; public support for start-up incubators providing capital, public land, expertise; engagement with public universities. - Context: venture capital often missing in developing countries, especially low-income countries. ### 3.C Labor Market — skills and employment incentives - Skills Development - Instruments: tax credits or subsidies to firms, industry associations, and skill councils that provide training; governments creating vocational training institutions partially funded through payroll levies in targeted sectors; apprenticeships and internships. - Effectiveness conditions: depends on collaboration with targeted sector in designing/delivering training; may require strengthening primary and secondary education. - Examples cited: India incubation centers in partnership with Indian Institute of Technology; Bangladesh Connecting Start-up Initiative; Philippines expanding training programs including internships and apprenticeships and investing in Information Technology and Business Management Process programs. - Labor Taxes - Instruments: selective reduction of payroll taxes in favored sectors; tax holidays or credits based on employment creation. - Constraints: to meet OECD regulations these incentives need to be very limited; specificity may violate WTO rules against export-targeted subsidies. - Evidence and risks: - Selective tax reductions can be successful but may provide windfalls with limited employment impact. - Policy design recommendations: impose minimal constraints on firms’ operations and productivity; avoid overly stringent hiring conditions; subject tax reductions and credits to sunset clauses to minimize abuse. ### 3.D Land Market — land access and Special Economic Zones - Cheap Land - Instruments: access to public land at below-market rates for new activity. - Rationale and risks: - Second-best response to land-tenure regulations limiting factory land access or use of land as collateral. - Attractive to foreign investors but incurs immediate fiscal cost. - SOEs often receive preferential access; neutral land distribution could enhance effectiveness. - Well-defined land and property rights are necessary incentives for agribusiness development. - Special Economic Zones (SEZs) - Instruments and benefits: better infrastructure and public services, corporate tax and import duty exemptions, streamlined regulations, other product market incentives. - Use cases: helpful where countrywide reforms face political economy constraints or governments cannot provide quality infrastructure economywide. - Evidence and risks: - Mixed track record. - Promoted growth in China, Jordan, Korea, Malaysia, Mauritius, and Singapore, though sometimes growth reflected associated trade liberalization rather than SEZs alone. - Many SEZs, particularly in sub-Saharan Africa, did not work well. - Success requires integrated strategy: conducive business environment within zones, strategic locations, technology upgrading and skills training, strong linkages with local economy. - Private-sector-led financing, development, and management minimize fiscal risks and improve success likelihood. ### 3.E Technology — R&D, transfer, and digitalization - Instruments: R&D tax incentives and subsidies; direct government R&D funding; public-private research consortia; support for digitalization via ICT infrastructure, cybersecurity, regulatory sandboxes, sector-specific digital platforms, and digital skills. - Evidence, costs, and design considerations: - Rationale: significant externalities from one firm’s R&D on productivity of others; can aid export diversification by reducing adoption risk of foreign technologies. - Empirical findings: numerous studies find a negative impact of taxes on firms’ R&D. - Costs: R&D subsidies can be expensive (example: costing half of a percentage point of GDP in Korea in the 1980s). - Returns: on average smaller in developing than in advanced economies because returns depend on human capital. - Design recommendations: R&D incentives in developing countries must be carefully designed and complemented by investments in education and infrastructure to strengthen technology absorption capacity. - Technology Transfer - Instruments: removing restrictions on foreign productive investment; bridging information gaps between foreign firms and local subcontractors; buying technology licenses for local producers; participating in patent pools; setting up training institutes to adapt technology. - Evidence and examples: Malaysia's Penang Development Corporation linking foreign investors and local subcontractors; international firms making Singapore their regional R&D hub due to high-standard research infrastructure developed with public funding. ### 4. Decision-Making Framework — targeting, implementation, governance - Framework addresses three key sets of questions: - Targeting: Which sectors to assist, and why? Which sectors/activities are characterized by market failures with substantial social costs? What resources and priorities exist? - Implementation: How to assist sectors? How much and what type of public support should be provided to minimize government failures? How should interventions be structured, monitored, evaluated, and time-limited? - Governance: Who decides which sectors to assist? How should needs be determined and by whom? How will governance structures mitigate government failure and informational uncertainty? - Implementation schematic (sectoral action plan) — steps: - identify sector → assess market and policy failures → articulate policy tools into a coordinated action plan → assess program performance regularly using objective market signals → adapt policy tools to changing environment. - Types of sector-specific market failures listed: coordination failures; learning by doing not internalized; learning externalities. - Sector-specific policy failures listed: trade policy bottlenecks (e.g., high tariffs on critical inputs, inadequate trade agreements); infrastructure deficits; regulatory costs and delays; skills shortages. - Coordinated action plan elements: vocational schools; electricity and roads; regulatory, administrative, and tariff relief; export and investment promotion agency; business coaching and technology transfer; tackle access to finance while encouraging competition and accountability. - Market-signal feedback: assess performance via objective signals and continuously adapt policies (example: adapt to COVID-19 changes in demand; license and diffuse technology while enforcing quality control and international standards). ### Box 1. A Sketch of Industrial Policy for Critical Medical Products — key elements - Context: severe shortages in critical medical products during the COVID-19 pandemic revealed market challenges and constraints. - Strategy principles (TIP): - Set ambitious, specific objectives with numerical targets, deadlines, and an endgame. - Build capabilities rapidly and adapt policies as conditions evolve. - Engage the private sector through coordination and support, while ensuring accountability. - Provide necessary public support (financing, incentives, coordination mechanisms) and ensure oversight. - Targeting example: - Objective: administering a scalable epidemiological test for 5–10 percent of the population every day, free and mandatory. - Numerical production target example: produce tests on the order of 5–10 percent of the population every day. - Implementation: - Establish a state taskforce reporting to a high-level council; involve science, treasury, central bank, development bank, and others; coordinate across government and private sector. - Task force authority: change incentives (moral suasion, tax breaks, financing) and enforce accountability for firms once objectives are agreed. - Access to financing example: via a development bank. - Collaboration and information-sharing: - Crisis times require shifting from competition toward collaboration to reduce coordination and informational frictions and gain speed. - Set up informal and fast information-sharing forums at different firm levels; use industry associations and public-private industry alliances. - Government incentives could encourage collaboration; historical examples include SEMATECH, proposed “Pandemic Testing Board,” and Operation Warp Speed. - Regulatory agencies and emergency mode: - Agencies must switch to emergency mode to perform quality control, help firms meet requirements quickly, and act as information disseminators on quality standards. - Clear specification of production targets aligns incentives and enables enforcement of accountability. - Testing infrastructure and logistics: - Mass deployment requires logistics, quarantine facilities, and financial support for the quarantined; bottlenecks depend on selected test technology. - Large-scale daily testing could use facilities and parking lots of schools and community centers. *Source: Executive Summary and Sections 1–3 (including Box 1) of the IMF Departmental Paper "Industrial Policy for Growth and Diversification."* ### Executive Summary ................................................................................................v ### Executive Summary ### Executive summary — key points - As countries recover from the COVID-19 pandemic they need to map a new path for development that promotes diversification, develops new industrial capabilities, and designs policies to achieve high and sustained growth. - A successful diversification strategy should tackle both broad policy failures (unfavorable business environment and investment climate) and sector-specific market failures. - This departmental paper presents a conceptual framework to analyze industrial policy, defined as targeted sectoral interventions. - Four guiding principles for policymakers: - Focus on the nature and magnitude of market failures that could justify targeted sectoral interventions. - Subject interventions to a cost-benefit test. - Analyze potential government failures (weak governance, limited administrative capacity). - Consider how to mitigate risks associated with weak governance. - The paper discusses commonly employed policy tools, their rationale, and associated pitfalls, and outlines a stylized decision-making framework. ### Introduction — contextual findings - Economic diversification is central to structural transformation and development; sustained growth and improved living standards are associated with diversification (IMF 2014). - Diversification involves transition from agriculture or mining toward a wider range of sectors, more sophisticated products, and higher-quality varieties of goods and services. - Drivers include infrastructure, education, fiscal and monetary policies, technology, and social development. - The COVID-19 pandemic highlighted vulnerabilities of countries lacking industrial capabilities (shortages of vaccines, tests, and medical goods — see Box 1). - Climate change (IMF 2020) and rising automation heighten the need for renewed diversification efforts. ### Guiding Principles: Market Failures versus Government Failures - Industrial policy is typically justified by sector-specific externalities where benefits of addressing them outweigh costs and risks of intervention. - Conditions for welfare-enhancing targeted intervention: - The intervention must address an externality. - The externality must not be resolvable through neutral means (e.g., better property rights). - The intervention must pass a cost-benefit test considering alternative public-fund uses. - Government failures must not undermine the intervention’s case. #### A. Externalities and sector selection — findings - Coordination failures and learning externalities imply firms may not internalize productivity gains; new sectors may need critical scale and scope requiring coordinated action (Murphy, Shleifer, and Vishny 1989). - Supply of specialized intermediate goods, skills, or infrastructure may be absent because suppliers lack incentives to enter an undeveloped sector. - Knowledge spillovers can boost productivity in other firms or sectors (Henderson 2007); policy promoting sectoral clusters may enable productivity gains (“economies of agglomeration”). - Learning externalities: firms bear discovery risk; successful entrants create information others can use, leading to potential under-entry or too little “self-discovery.” (Hausmann and Rodrik 2003). - Information frictions in export markets may impede reputation-building (Atkin, Khandelwal, and Osman 2017). - Externalities argument for intervention is strongest in modern, tradable sectors (Annex 1), especially those with: - High R&D intensity and relative sophistication (Cherif and Hasanov 2019b). - Manufacturing characteristics: high productivity growth and potential convergence to world frontier (Rodrik 2013). - Modern services (transport and communications, financial intermediation, business services) showing increasing sophistication, tradability, scale, innovation, and learning-by-doing (Hallward-Driemeier and Nayyar 2017); AI and blockchain may further enhance productivity and spillovers. - Emerging industries with similar characteristics: clean tech (renewable energy, electric vehicles, and batteries), robotics, and 3D printing. - Modern agri-business (e.g., salmon farming) may also feature significant knowledge spillovers (Benavente 2016). - Sector distribution reflects exogenous factors (geography, climate) via transport costs and access to inputs/markets. - Short-term “quick win” sectors (traditional services, agricultural processing, textiles, tourism, call centers) require less state intervention and can employ many workers and generate resources for advanced sectors, but exclusive focus on them risks missing transformative technology and innovation-led growth (Aghion, Cherif, and Hasanov 2021). #### B. Cost-benefit test — guidance and findings - Active policy must pass an appropriate cost-benefit test. - Costs include invested amounts plus administrative and efficiency costs of raising tax revenue (especially high in developing countries; Besley and Persson 2014). - Benefits equal the difference in value added between the project and counterfactual uses of labor and capital (unless those resources would have remained unemployed). - Benefits should include spillovers, learning-by-doing, and social value of reduced volatility. - Distributional/social implications matter: will the project open opportunities or mainly transfer funds to a few beneficiaries (Freund and Oliver 2016)? - Cost-benefit analysis is difficult: costs easier to assess; benefits uncertain and future-dated. Still useful as a first-approximation if risks and opportunities are appropriately weighted. - Social rate of return should exceed best alternative return to funds, including returning money to taxpayers or intervening in sectors with greater spillovers. - Some externalities may be resolved through property-rights assignment (e.g., auctioning the right to construct coordinated assets), but this can create monopoly risks and presumes regulatory capacity. - Such solutions may be less appropriate where coordination involves many actors with specialized capabilities. #### C. Government failure: incentives and information — risks - Government actors respond to incentives like private actors; risks include: - Rent-seeking, corruption, mercantilist pressures, and capture by special interests — amplified in weak institutional environments. - Legislators directing funds to their districts regardless of social optimality. - Agencies competing for influence and seeking program continuation irrespective of social contribution. - Citizens face costs to monitor program effectiveness; monitoring and accountability may be weak. - Consequences: - Governments may alter programs, misuse opportunities (e.g., SEZs used for land appropriation for real-estate), announce policies for electoral gains without implementation, or fail to implement exit strategies (infant-industry protection is hard to withdraw). - Informational requirements for rigorous evaluation are high; some information is unobtainable. Incentive issues may deter transparent monitoring and evaluation, amplifying distorted outcomes and unintended consequences. #### D. Designing policy to mitigate risks — recommendations - Principles to minimize government-failure risk: - Demand accountability for support received via specific performance targets (e.g., export market shares) and willingness to cut losses. - Maintain competition: support sectors rather than firms; focus on export orientation (contrasted with import-substitution and high-tariff approaches). - Use independent, appropriately qualified experts to select projects for public support (Tirole 2017). - Complement interventions with reforms to control corruption. - Avoid overly strict accountability that paralyzes action—some unavoidable risks remain. - Strategies to reduce informational uncertainty: - Analyze how much money is at risk if uncertain benefits fail to materialize (costs easier to establish than benefits). - Pre-screen proposals with back-of-the-envelope calculations to check likelihood of meeting cost-benefit standards. - Require interventions to bear the burden of proving merits; involve the private sector from the outset to incentivize data generation. - Invest in information gathering to assess net benefits, benchmark costs internationally, and evaluate past programs after conclusion. - Pilot policy proposals on small scale to test feasibility, costs, and benefits before scaling up. *Source: Executive Summary and Sections 1–2 of the IMF Departmental Paper "Industrial Policy for Growth and Diversification."* ### 3. Policy Tools ### 3. Policy Tools ### A. Product Market - Taxonomy: five categories of instruments considered are (1) product market, (2) capital market, (3) labor market, (4) land market, and (5) technology. - Trade Policy - Instruments: import tariffs and nontariff barriers, including import quotas, local content requirements, and export subsidies; differential tax rates for profits from export sales; import-tariff rebates on imported intermediates; credit lines for exports; subsidies to foreign investors on the purchase of domestic inputs. - Constraints: global trading regime restricts many instruments; alternative tools should ensure consistency with World Trade Organization (WTO) rules. - Evidence and risks: - Industry case studies find that protection often led to net welfare losses (Harrison and Rodriguez-Clare 2010), even in East Asian miracle economies (Ohashi 2005). - Tariffs on capital and intermediate goods are especially likely to reduce growth (Estevadeordal and Taylor 2013). - Protection of skill-intensive sectors is more likely to be associated with faster growth, at least in countries with good governance (Nunn and Trefler 2010). - Tax Incentives to Promote Investment - Instruments: tax holidays and exemptions, special corporate tax structures, targeted allowances, subsidized infrastructure, accelerated depreciation schemes, investment tax credits, super deductions, profit-based tax holidays. - Evidence and risks: - Tax incentives can significantly erode revenues without achieving offsetting benefits unless properly designed and time-bound (IMF 2015, 2016; IMF and others 2015; Pack and Saggi 2006). - Well-targeted incentives reducing the cost of capital have had some success in advanced economies; open-ended and profit-based tax holidays are less effective and can erode the tax base indefinitely (Villela, Lemgruber, and Jorratt 2010, Cubeddu and others 2008). - Tax incentives commonly used to attract FDI are often found to be largely ineffective, with their costs exceeding any spillovers. - Complementary inputs and policies needed: macroeconomic stability, a minimum level of human capital, high-quality infrastructure, openness to trade, developed financial markets, non-stringent capital controls, attractive business environment including strong property rights and efficient regulation (McIntyre 2017, James 2013). - Governance recommendation: tax incentives should be governed by tax laws with minimum discretion; beneficiaries should file returns even where no tax obligation exists to measure costs and outcomes. - The State as a Producer and Consumer - Roles: state participation via state-owned enterprises (SOEs) and through public procurement. - Risks and benefits: - Direct involvement often proven costly with hidden subsidies, direct transfers, and overstaffing; SOEs tend to crowd out private investment. - SOEs can generate positive human capital and R&D spillovers (example: technological externalities from Airbus). - Governance recommendation: clear mandates, strong governance rules, high transparency, appropriate manager incentives, effective oversight and risk mitigation (IMF 2020b; World Bank 2014, 2015). - Measures to Reduce Informational Frictions - Instruments: promotion agencies that match buyers with suppliers; export promotion agencies organizing fairs, linkage programs, quality certification schemes; “soft industrial policy.” - Effectiveness: likely to boost exports when providing a clear and effective one-stop shop; fragmented agencies with unclear mandates are less effective (Lederman, Olarreaga, and Payton 2010, Cadot and others 2015). ### B. Capital Market - Rationale: financing to enter new sectors is difficult where financial sector is underdeveloped, prudential restrictions shorten investment horizons, and collateral is hard to establish; public sector may have longer horizons or better information. - Directed and Direct Lending - Instruments: instruct commercial banks to allocate lending to particular sectors; public sector lending via specialized development banks or export-import banks. - Evidence and risks: - Directed lending can boost production when firms are severely credit constrained (Banerjee and Duflo 2014) but can undermine financial sector profitability. - Public lending increases public borrowing requirement; subsidized interest rates amount to fiscal subsidies. - Large-scale failures of development banks in the 1970s and 1980s led many to be privatized or closed (Thorne and du Toit 2009). - Development banks often face large nonperforming loans and lack well-defined development mandates; may crowd out private intermediaries (World Bank 2018). - Credit Guarantees - Instruments: government loan guarantees to support credit flows from commercial banks or investors. - Recent use: expanded considerably in the wake of the COVID-19 pandemic (IMF 2020c). - Risks and evidence: - Guarantees create contingent liabilities for the public sector; beneficiaries may misuse funds. - Improper use can adversely affect public financial management and fiscal policy. - Few rigorous evaluations; difficult to identify schemes that resulted in appreciable increases in lending; several have suffered significant losses (ADB 2016; OECD 2017a). - Venture Capital and Incubators - Instruments: public intervention to develop venture capital/private equity sectors; public bodies acting as venture capital firms; public support for start-up incubators providing capital, public land, expertise; engagement with public universities. - Context: venture capital often missing in developing countries, especially low-income countries. ### C. Labor Market - Skills Development - Instruments: tax credits or subsidies to firms, industry associations, and skill councils that provide training; governments creating vocational training institutions partially funded through payroll levies in targeted sectors; apprenticeships and internships. - Effectiveness conditions: depends on collaboration with targeted sector in designing/delivering training; may require strengthening primary and secondary education. - Examples: - India: setting up incubation centers across the country in partnership with Indian Institute of Technology. - Bangladesh: Connecting Start-up Initiative provides support to new ventures. - Philippines: upgrading workforce skills by expanding training programs, including internships and apprenticeships, and investing in Information Technology and Business Management Process programs to develop skills in animation, data analytics, and cloud computing. - Labor Taxes - Instruments: selective reduction of payroll taxes in favored sectors; tax holidays or credits based on employment creation. - Constraints: to meet OECD regulations these incentives need to be very limited; specificity may violate WTO rules against export-targeted subsidies. - Evidence and risks: - Selective tax reductions can be successful (Manelici and Pantea 2021) but may provide windfalls with limited employment impact. - Policy design recommendations: impose minimal constraints on firms’ operations and productivity; avoid overly stringent hiring conditions (e.g., local labor-content requirements); subject tax reductions and credits to sunset clauses to minimize abuse. ### D. Land Market - Cheap Land - Instruments: access to public land at below-market rates for new activity. - Rationale and risks: - Second-best response to land-tenure regulations limiting factory land access or use of land as collateral. - Attractive to foreign investors but incurs immediate fiscal cost. - SOEs often receive preferential access; neutral land distribution could enhance effectiveness. - Well-defined land and property rights are necessary incentives for agribusiness development. - Special Economic Zones (SEZs) - Instruments and benefits: better infrastructure and public services, corporate tax and import duty exemptions, streamlined regulations, other product market incentives. - Use cases: helpful where countrywide reforms face political economy constraints or governments cannot provide quality infrastructure economywide. - Evidence and risks: - Mixed track record (World Bank 2017). - Promoted growth in China, Jordan, Korea, Malaysia, Mauritius, and Singapore (Wang 2013, Leong 2013), though sometimes growth reflected associated trade liberalization rather than SEZs alone. - Many SEZs, particularly in sub-Saharan Africa, did not work well. - Success requires integrated strategy: conducive business environment within zones, strategic locations, technology upgrading and skills training, strong linkages with local economy (Zeng 2015). - Private-sector-led financing, development, and management minimize fiscal risks and improve success likelihood. ### E. Technology - Instruments: R&D tax incentives and subsidies; direct government R&D funding; public-private research consortia; support for digitalization via ICT infrastructure, cybersecurity, regulatory sandboxes, sector-specific digital platforms, and digital skills. - Evidence, costs, and design considerations: - Rationale: significant externalities from one firm’s R&D on productivity of others; can aid export diversification by reducing adoption risk of foreign technologies (Hausmann and others 2007). - Empirical findings: numerous studies find a negative impact of taxes on firms’ R&D. - Costs: R&D subsidies can be expensive (example: costing half of a percentage point of GDP in Korea in the 1980s; UNCTAD 2016). - Returns: on average smaller in developing than in advanced economies (Goñi and Maloney 2017) because returns depend on human capital. - Design recommendations: R&D incentives in developing countries must be carefully designed and complemented by investments in education and infrastructure to strengthen technology absorption capacity (IMF 2016). - Technology Transfer - Instruments: removing restrictions on foreign productive investment; bridging information gaps between foreign firms and local subcontractors; buying technology licenses for local producers; participating in patent pools; setting up training institutes to adapt technology. - Evidence and examples: - In Malaysia in the 1980s, the Penang Development Corporation linked foreign investors and local subcontractors to help the electronics sector move to higher-skill activities (Weiss 2015). - Many international firms made Singapore their regional R&D hub due to high-standard research infrastructure developed with public funding (Weiss 2015). ### 4. Decision-Making Framework - Approach: no one-size-fits-all; framework addresses three key sets of questions to choose policy tools suited to country circumstances and implementation needs: - Targeting: Which sectors to assist, and why? Which sectors/activities are characterized by market failures with substantial social costs? What resources and priorities exist? - Implementation: How to assist sectors? How much and what type of public support should be provided to minimize government failures? How should interventions be structured, monitored, evaluated, and time-limited? - Governance: Who decides which sectors to assist? How should needs be determined and by whom? How will governance structures mitigate government failure and informational uncertainty? - Implementation schematic (sectoral action plan) - Steps: identify sector → assess market and policy failures → articulate policy tools into a coordinated action plan → assess program performance regularly using objective market signals → adapt policy tools to changing environment. - Types of sector-specific market failures listed: coordination failures; learning by doing not internalized; learning externalities. - Sector-specific policy failures listed: trade policy bottlenecks (e.g., high tariffs on critical inputs, inadequate trade agreements); infrastructure deficits; regulatory costs and delays; skills shortages. - Coordinated action plan elements: vocational schools; electricity and roads; regulatory, administrative, and tariff relief; export and investment promotion agency; business coaching and technology transfer; tackle access to finance while encouraging competition and accountability. - Market-signal feedback: assess performance via objective signals (example: link low export growth to specific bottlenecks) and continuously adapt policies (example: adapt to COVID-19 changes in demand; license and diffuse technology while enforcing quality control and international standards). *IMF DEPARTMENTAL PAPERS • Industrial Policy for Growth and Diversification — Section 3. Policy Tools* ### Box 1. A Sketch of Industrial Policy for Critical Medical Products ### Box 1. A Sketch of Industrial Policy for Critical Medical Products ### Context and purpose - Severe shortages in critical medical products during the COVID-19 pandemic exposed market challenges and constraints, including in several advanced economies. - The box sketches state policies needed to ramp up production of test kits as an example of critical medical goods, based on the “True Industrial Policy” (TIP) principles of setting ambitious goals, building capabilities and adapting quickly, engaging the private sector, and providing necessary support while ensuring accountability (Cherif and Hasanov 2019b, 2019c; Cherif and Hasanov 2020). ### Strategy principles (TIP) - Set ambitious, specific objectives with numerical targets, deadlines, and an endgame. - Build capabilities rapidly and adapt policies as conditions evolve. - Engage the private sector through coordination and support, while ensuring accountability. - Provide necessary public support (financing, incentives, coordination mechanisms) and ensure oversight. ### Targeting - Example objective: administering a scalable epidemiological test for 5–10 percent of the population every day, free and mandatory. - Numerical production target example: produce tests on the order of 5–10 percent of the population every day. - Deadlines example: by end-month. - Endgame example: virus-free within weeks and relying on an early-warning system thereafter. ### Implementation - Establish a state taskforce responsible for ramping up production, directly reporting to the high-level council in charge of applying the strategy. - Involve major actors across different government agencies and levels and the private sector, with regular meetings and communications to the public. - Include key agencies such as science, treasury, central bank, development bank, and others as part of the council. ### Governance and accountability - The task force should have authority to change incentives (through moral suasion, tax breaks, or financing) and to enforce accountability (quality and quantity) for firms once clear objectives have been agreed with them. - The task force would run the operation and coordinate across firms, the value chain, and government agencies. - Access to financing would be provided (for instance, via a development bank). ### Collaboration, information-sharing, and incentives - Crisis times require shifting from competition toward collaboration to reduce coordination and informational frictions and gain speed. - Information-sharing among firms on production processes, technology, and resources helps combine efforts to solve common bottlenecks and supports new entrants learning from incumbents. - Set up informal and fast information-sharing forums at different firm levels (for example, R&D personnel, engineers, and technicians), use industry associations and public-private industry alliances to promote knowledge flows, coordination, and collaboration. - Government incentives could encourage collaboration; illustrative historical/examples: - SEMATECH alliance of US semiconductor companies in the 1980s. - Proposal for a “Pandemic Testing Board” modeled on the WWII war production board (Maier and Kumekawa 2020). - Operation Warp Speed supporting vaccine development and manufacturing. - Analogous crisis-coordination role played by the US Federal Reserve Board during the 2008 financial crisis. ### Regulatory agencies and emergency mode - Relevant regulatory and administrative agencies (for instance, agencies regulating medical products) need to switch to an emergency mode operation. - Responsibilities in emergency mode: - Perform quality control. - Help firms meet needed requirements within the shortest time possible. - Act as an information disseminator on how to reach quality standards. - Clear specification of production targets (number of test kits, amounts of inputs needed, specific infrastructure required) aligns incentives and enables enforcement of accountability. - Consider mechanisms to share burdens among firms and incentive mechanisms to both compete and collaborate (for example, prizes, tax breaks, or loan guarantees). ### Testing infrastructure and logistics - Mass deployment of tests requires planning the whole testing infrastructure: logistical support, potential quarantine facilities, and financial support for the quarantined. - Bottlenecks may depend on selected test technology (for example, tests requiring face-to-face interaction necessitate sufficient protective gear for testing centers). - Enforcing isolation of infected people in quarantine requires similar planning. - Large-scale daily testing could use facilities and parking lots of schools and community centers to make the task manageable. *IMF DEPARTMENTAL PAPERS • Industrial Policy for Growth and Diversification — Box 1. 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