## ELIMINATING THE PRODUCTIVITY DRAG

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**Canonical URL:** [ELIMINATING THE PRODUCTIVITY DRAG](https://www.imf.org/-/media/files/publications/fandd/article/2024/09/li-productivity.pdf)

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### Overview
- The global economy has been struggling to regain footing since the 2008–09 global financial crisis, with medium-term growth forecasts being downgraded.
- Without timely policy interventions or breakthroughs in technology and its adoption, global growth could stagnate at just 2.8 percent by the end of the decade.
- This projection represents a drop of 1 percentage point from prepandemic levels.
- The United States leads the sample countries in allocative efficiency; if less efficient countries narrow their gap with the United States by 15 percent, it would add about 1.2 percentage points to annual global growth.
- Structural reforms addressing regulatory barriers, labor market rigidity, and access to financing are key to achieving these gains.

### What drives productivity
- Productivity growth is driven by:
  - Within-firm improvements (better technology, improved management practices, innovative processes).
  - Economy-wide allocative efficiency (how well resources are distributed across businesses for their most productive uses).
- Trends in measured productivity growth:
  - Advanced economies: annual productivity growth plunged from 1.4 percent during 1995–2000 to 0.4 percent after the pandemic.
  - Emerging market economies: dropped from 2.5 percent during 2001–07 to 0.8 percent.
  - Low-income countries: productivity growth fell from 2 percent during 2001–07 to nearly zero after the pandemic.
- Diminishing returns to R&D mentioned (sector example: semiconductor industry requires more researchers to double chip density); rapid gains in information and communications technology have plateaued since the early 2000s.

### Addressing misallocation
- Misallocation of capital and labor across companies within sectors has increased and has been dragging down productivity growth by an average of 0.6 percentage point annually.
- Without this increase in misallocation, productivity growth could have been 50 percent higher.
- Two-thirds of the observed misallocation is attributable to persistent structural issues (regulatory barriers, rigid labor markets, financing constraints, lack of trade openness).
- Targeted policy interventions to reduce structural frictions could substantially boost productivity and foster growth.
- Policy examples that support reallocation and productivity:
  - Reduction of barriers to market entry and increased competition (historical example cited: India’s 1991 deregulation removing compulsory industrial licensing).
  - Liberalization of financial markets to enable businesses to access growth funding.
  - Reducing labor market rigidities to lower costs and facilitate movement from less productive to more productive sectors (example: Brazil’s past stringent labor regulations increasing informal sector employment).
  - Tackling corruption and weak property rights through governance and institutional reforms.

### Role of emerging technologies
- Emerging technologies with potential to lift productivity include artificial intelligence, supercomputer chips, biotechnology, and green technologies.
- AI examples: optimizing supply chains, reducing operational costs, improving customer service; in health care, AI-driven diagnostics and personalized medicine; in manufacturing, AI-powered automation increases production speeds and reduces errors.
- Governments should foster innovation and adoption ecosystems that support creativity and minimize frictions in reallocation of research resources.

### A thought experiment and potential impact
- Thought experiment: if every country narrowed policy gaps with the best-performing economy (in labor market flexibility, financial market liberalization, trade liberalization, and regulation of certain product markets) by 15 percent:
  - The drag on annual productivity growth from allocative inefficiency could be eliminated.
  - This would reverse the decline in productivity and boost growth (illustrated earlier as about 1.2 percentage points to annual global growth).

### Regional cases and country vignettes
- Euro Area:
  - Productivity growth has lagged the United States since the 1990s.
  - Lack of a truly integrated market for goods, services, labor, and capital limits economies of scale and growth, especially for disruptive start-ups.
  - Inefficient insolvency frameworks slow exit of unproductive companies and hinder resource allocation.
  - Aging population, skills mismatches, and other labor challenges discourage job churn needed for productivity growth.
  - A stronger single market would improve competition and allocative efficiency.
- Japan:
  - Total factor productivity growth recovered in the 2010s as firms invested in software and digitalization, but recovery did not last and productivity growth slowed again.
  - Despite being one of the world’s top spenders on research and development as a share of GDP, Japan has not made sufficient technological breakthroughs to restore productivity to historical levels.
  - A widening gap between high- and low-productivity companies reduces allocative efficiency; poor-performing firms continue operating for years before exiting.
- Brazil:
  - Worker productivity increased since a 2017 labor reform that led to a decline in litigation cases and associated costs.
  - Implementation of a 2023 value-added tax reform is expected to improve resource allocation, particularly in manufacturing, boost investment, and increase formal-sector activities, raising economic growth by 0.3-0.5 percentage points per year.
  - Greater hydrocarbon output is expected to lift medium-term growth; investment in green growth opportunities could lift economic potential further.
- China:
  - Rapid transformation and global integration drove decades of strong performance, but growth has slowed and is projected to decelerate further amid an aging population and declining productivity growth.
  - Allocation of capital and labor across companies has become less efficient in the service sector (which accounts for more than half of value added).
  - Less productive services companies command too large a market share while more productive firms remain too small due to difficulty attracting capital and labor.
  - Recommended priorities: reforms to improve allocative efficiency, reforming state-owned enterprises, removing protectionist barriers, and further opening up to international trade in services.

### Key statistics and findings
- Global growth could stagnate at 2.8 percent by the end of the decade without interventions.
- Gap-closing scenario: narrowing policy gaps with the United States by 15 percent would add about 1.2 percentage points to annual global growth.
- Allocative inefficiency has reduced productivity growth by an average of 0.6 percentage point annually.
- Without increased misallocation, productivity growth could have been 50 percent higher.
- Productivity growth by region/time:
  - Advanced economies: 1.4 percent (1995–2000) → 0.4 percent (after the pandemic).
  - Emerging market economies: 2.5 percent (2001–07) → 0.8 percent (after the financial crisis/pandemic period).
  - Low-income countries: 2 percent (2001–07) → nearly zero (after the pandemic).
- Brazil growth boost from 2023 VAT reform: 0.3-0.5 percentage points per year.

### Policy recommendations
- Implement structural reforms to reduce regulatory barriers, labor market rigidities, and financing constraints to improve allocative efficiency.
- Reduce barriers to market entry and promote competition to allow more productive firms to expand.
- Liberalize financial markets to enable high-productivity firms to access capital.
- Reduce labor market frictions to facilitate worker movement and job churn.
- Strengthen governance: tackle corruption and reinforce property rights to support efficient resource allocation.
- Foster innovation ecosystems and minimize frictions in reallocation of research resources to accelerate adoption of emerging technologies (AI, supercomputer chips, biotechnology, green technologies).
- Prioritize country-specific reforms (examples: reforming state-owned enterprises and opening up services trade in China; completing single-market integration in the Euro Area; sustaining digital and R&D advances and improving exit mechanisms in Japan; continuing Brazil’s tax and labor reforms and green investment).

*This article draws on Chapter 3 of the IMF’s April 2024 World Economic Outlook.*

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_Source: https://www.imf.org/-/media/files/publications/fandd/article/2024/09/li-productivity.pdf_