The Productivity Gap

Standard development economics anticipates that the composition of a country’s labor force will go hand in hand with the composition of output, reflected in the division between the primary, secondary, and services sectors. But contemporary India, as well as several other countries across the global South, are challenging this expectation: changes in output between the sectors have preceded changes in the composition of the labor market. 

The gap bears political and economic implications: grossly inadequate industrial job creation surfaces as an unmanageably vast informal economy existing side by side with the organized economy. It shows no clear sign of decreasing in importance with industrialization, and this informality overlaps with the same agricultural, industrial, and service divisions of the formal sector. 

Today, about 90 percent of the Indian labor force is engaged in the informal economy, producing about 46 percent of output. This makes labor productivity in the informal sector just above half of the national average. The remaining 55 percent of GDP is produced by only about 10 percent of the labor force in the formal sector, with 5.5 times the labor productivity of the national average. Only about 5 percent of that labor force is employed in large businesses composed of public and private corporate industries and services, including public utilities, where labor productivity gaps are much higher.

This enormous difference in labor productivity is a double-edged sword. It is the potential source of a large increase in output if, as Arthur Lewis predicted, there is a shift from small agriculture to large, organized industry. Both Lewis and Kuznets anticipated that transitioning from the informal to the formal sector would generate enormous productivity gains, the main source of economic growth. 

But the productivity gap can also harm employment, as any given level of output can be produced with less labor. About 11 million people currently enter the labor force every year, with at least 20 million unemployed carrying over from the previous year. Assuming an average 7.5 percent unemployment, these figures yield an annual 4.1 percent unemployment growth in a population that is growing at approximately 1.9 percent. 

Classical development economists overlooked this problem. They failed to consider that the formal sector may face constraints to market size as a result of insufficient effective demand—which makes it unprofitable for organized industry to expand production beyond what the market will take—and be unable to accommodate most of the displaced workers from agriculture. This tendency was predicted by none other than Adam Smith, who observed that the extent of division of labor is limited by the size of the market. 

To stabilize the worsening unemployment crisis, Indian employment has to grow at a minimum of 6 percent per annum. Unfortunately, in the forthcoming Indian elections, job creation has not been on the table for Prime Minister Narendra Modi’s Bharatiya Janata Party (BJP). Instead, the party in power reflects conventional development thinking that industrialization at a faster pace will do the job. In what follows, I challenge the expectations of classical development economics and reflect on policy paths out of this predicament. 

Kuznets, Lewis, and Schumpeter

Three prominent economic theorists form the backbone of classical development economics: Joseph Schumpeter’s understanding of economic evolution as “a distinct process generated by the economic system itself” anticipates that elements endogenous to capitalism will force innovation and economic development through creative destruction.¹ “Frictional unemployment” is held to be an integral part of the general process of creative destruction—with employment rising and falling according to the needs of new, innovative industries.

In a similar vein of optimism, the highly contested Kuznets Curve argues that income inequality follows a U shape with higher per capita income: it rises during early industrialization and then declines as more and more workers shift away from agriculture and into industry. For developing countries, the theory indicates that the best course of action is to simply wait until employment adapts to rising productivity. 

Finally, the Lewis model anticipates that industrial development will progressively draw on an “abundance of labor” from agricultural production, resulting in a long period of “labor transfer.” During this period, wages are expected to be slightly above subsistence—enough to attract rural workers. Wages are expected to rise when the “turning point” of industrialization is reached with all surplus labor absorbed in industry and excess supply of labor eliminated. 

These classical theories of development tell an optimistic story but suffer from two key weaknesses. First, all three theories are concerned with development in the “long run”—a time frame which is nearly meaningless in social and political terms, particularly in democracies with elections at regular intervals. Second, the theories neglect the possibility that inadequate effective demand would constrain the size of the industrial sector. It is the “elephant in the room” that conventional development theory ignores. 

Corporate industrialization in the short run

In recent decades, the Indian economy has exhibited continually growing GDP alongside growing unemployment. This “jobless growth” is characterized by rising output in organized industries combined with overcrowding and declining livelihood in the unorganized sector.² While the winners of this development benefit from higher productivity, the losers are left uncompensated, eking out an existence in the unorganized sector. The dispossession of those displaced from small-scale agriculture due to land acquisition is invisible in this growth model; such conditions drove the farmers’ protests in 2021.

The cost of industrialization is borne by the most vulnerable sections of society. High prices, increasing costs of living, and heavy indirect taxes are general symptoms, but the worst effects are hidden from the public eye. In India, the Adivasis, roughly 8 percent of the population, account for 40 percent of the displaced population, meaning they have a five times higher likelihood of being displaced in the name of development. In the absence of reliable data on displacement and caste, we can only note that the incidence of land acquisition falls disproportionately hard on the small not large holders. Around half of the Scheduled Caste households had holdings less than 0.4 hectares; their average holding is 0.52 hectares which is about half the average holding of other households (1.05 hectares, and only 6 percent of them had more than 2 hectares of land.)³ Acquisition of land on a disproportionately large scale in the name of economic development deepens economic inequality and exacerbates social divisions in the countryside. 

Almost ironically, the higher the labor productivity gap between organized industry and traditional agriculture, the more severe this phenomenon of unemployment for any given market size. Our economic analysis must be relevant to the ever-present short run. Insufficient effective demand is not a problem that can be done away with through appealing to international trade and investments. The notion that foreign trade might relax demand constraints only works given a trade surplus. But India has faced a significant and persistent trade deficit, which stood at $78 billion in 2023, down from $121.62 billion the year before. As a result, the foreign trade multiplier works in reverse to subtract rather than add to the size of the domestic market.

Attempts to enhance international competitiveness and reduce the trade deficit through greater mechanization and robotization have only increased the productivity gap between large and small businesses. With high import intensity of mechanization, the additional import often exceeds additional export at the margin. This contributes to a persistent trade deficit without boosting India’s international competitiveness. Instead, mechanization has encouraged further labor saving production processes only to worsen the unemployment problem.

Rising “portfolio investment” intended to compensate for the declining demand generated by low wages and flexible labor markets neither expands domestic market size nor the productive capacity of the economy.⁴ It does, however, influence the ownership pattern of stocks. The upper echelons of  Indian society have been pleased with their luxurious consumption baskets, made possible with partially or totally imported goods sustainable only by international capital inflows and higher income accruing to them from a buoyant stock market. “Portfolio investment” has not only eased the foreign exchange constraint on elite consumption, but it has also helped widen the functional income gap between income from property and from work.

Growing inequality is promoted for incentivizing private investment by large businesses. Heavily subsidized land prices and related natural resources for corporations encourage dispossession. Tax breaks, cultivated blindness to willful defaults of bank loans and frauds committed by favored corporations, and generous contributions to the BJP’s election funds together present a picture of comfortable mutualism between the government and big business while unemployment soars. 

Large scale land acquisition for industrialization adds to the pressure of unemployment with no solution in sight. As repeatedly pointed out in the many reports of the Auditor General of India, speculative land ownership by corporations, alongside land banks owned by the government, have made a large percentage of land acquisitions idle, unused for industrialization while exacerbating unemployment. 

Doing away with classical development theories opens the way for pro-poor intervention and for the state to cultivate a fiscal mechanism to compensate the losers of development processes. Resolving the crisis of unemployment poses an opportunity to resist the class-based discrimination enacted by large corporations in collaboration with the state.⁵

Policy solutions

Instead of increasing overall labor productivity in the economy by trying to transfer labor from low productivity small agriculture to high productivity organized industry, our focus should be on reducing the gap between the two, namely by raising the productivity of small agriculture. We must focus on raising the productivity of land, and not labor: infrastructure development, including road communication and connectivity, should center around the countryside rather than aspiring towards world class connectivity among cities amid a sea of destitution. Increasing land productivity usually improves the income of not only the landowner but of the larger community. Increasing local purchasing power creates a local market and weakens the demand constraint faced by organized industry. 

Land productivity ought to be defined inclusively, taking into account all types of agricultural produce, including subsistence and commercial crops, fishing, and animal husbandry. Forests, rivers, water bodies’ medicinal plants, and marine products of the commons should be demarcated as public rather than private goods for raising land productivity. The relative price of crops is a particularly important policy instrument, and reaching such an inclusive optimal cropping pattern should entail decreasing rather than increasing dependence on inputs purchased from markets. Less dependence on market-based inputs would impact the cost of cultivation and the recurring problem of debts that disproportionately harm small farmers. 

A minimum support price system for agricultural produce—a central issue in the farmers’ massive mobilization in 2021—as well as insurance for crop failures are imperatives of our time, both as income support and price incentive. Under measures of collective water, land, and forest management aided by the Panchayat government, regular droughts, floods, and crop failures could hopefully inflict less distress. The village-level Panchayat government should also manage the use of all commons and extend employment guarantee schemes towards creating public assets and improving the commons. 

A main source of the increase in land productivity would result from better use of unemployed and underemployed labor. Labor mobilization on a massive scale for development of the countryside was one of the most spectacularly successful features of post-revolution China and Vietnam. In the Indian case, the Rural Employment Guarantee in the early 2000s marked a step towards the right direction, but newer iterations must partner with local Panchayats with sufficient fiscal and administrative autonomy. Such a provision already exists in the Indian Constitution, but it is rarely implemented. 

To improve employment outlook, land productivity on small farms must be complemented by rapid expansion in the services sector. While small scale industries and services could respond to increased demand from higher-earning small farmers, the greatest potential employment growth would come from the expansion of basic welfare services like primary health and education. These are desperately needed public goods, and they can also form a social wage, providing an alternative to the current attempts to increase private monetary wages meant to allow individuals to afford basic necessities. 

Finally, land acquisition ought to come with the payment of a minimum annual rent to those dispossessed. This will go a long way towards minimizing the destitution of tenants, agricultural laborers, fishermen in coastal areas, and forest dwellers, among others. Across these development initiatives, we must defend the decentralization of decision-making and local autonomy that have been integral to the Indian federal structure. India’s path to development cannot take the form of over-centralization in the hands of government-supported corporations.

This piece is adapted from a recently published article in the Journal of Brazilian Economics.