THE MIDDLE-INCOME TRAP: SYNTHESIS OF THE WORLD BANK REPORT

Alibek KONKAKOV

Director of Public Administration and Policy

In early August, the World Bank released its annual flagship World Development Report, which this year focused on the “Middle-Income Trap.” The press release accompanying the report describes it as presenting a “modern framework for delivering quality growth in the 21st century” and offering the first comprehensive action plan for developing countries to escape the trap.

This article presents a substantive summary of the report through the lens of its relevance to Kazakhstan.

The “Middle-Income Trap”

The report vividly describes a core fact: over the past 34 years, only 34 countries have successfully transitioned from middle-income to high-income status. Collectively, these countries have fewer than 250 million people — roughly the population of Pakistan, which itself is a middle-income country.

At the same time, 108 countries – home to over 6 billion people – remain stuck in the middle-income category. Many of them have made impressive progress, overcoming poverty and graduating from low-income status. However, their ambitions to continue progressing now clash with harsh economic realities: rising debt levels, aging populations at home, and growing protectionism and demands for accelerated energy transition abroad.

Historically, since the 1970s, the median middle-income country has experienced stagnation in per capita income, remaining at around 11% of U.S. per capita GDP – roughly equivalent to $8,000 today. Countries with weaker institutions and lower economic freedom tend to experience stagnation earlier. Altogether, only 25 million people live in countries whose per capita income surpasses that of the United States.

The key reason behind stagnation is the inability of countries to adapt their development strategies. Many remain reliant on capital accumulation, but as capital stock grows, marginal returns naturally decline (due to the law of diminishing returns). If the only difference between middle- and high-income countries were capital, then per capita incomes in the former would be about 75% of the U.S. level – instead of the actual one-fifth.

What middle-income countries truly need for further development is to increase the complexity of their economic structures. This is mainly expressed through a more sophisticated export basket, and in every country that transitioned to high-income status, rising income has correlated with increasing export complexity – regardless of whether exports became more diversified.

The Strategy of the Three “I’s”

To foster structural complexity, the report proposes a development strategy based on the three “I’s”: Investment, Technological Injections, and Innovation.

“Low-income countries can focus solely on policies designed to increase investment—the 1i approach. Once they attain lower-middle-income status, they will need to shift gears and expand the policy mix to 2i, investment + infusion. At the upper-middle-income level, countries will have to shift gears again to 3i: investment + infusion + innovation. At this stage, countries do not just borrow ideas from the global frontiers of technology but also to push the frontiers outward.”

Thus, middle-income countries must go through not one but two transitions. Crucially, it’s impossible to skip directly from investment-driven to innovation-driven growth. The technological injection stage cannot be ignored. Creating an attractive investment climate must be gradually paired with policies to attract and diffuse new ideas, knowledge, and technologies.

The shift to an innovation-driven economy is more uncertain. Technological injections require flows of capital and knowledge. Innovation, in turn, also requires human capital exchange, meaning individual freedoms, urban livability, and strong institutions must be in place.

The Key to a Successful Transition

Transitions across the three stages are neither smooth nor linear. Success depends on society’s ability to balance three forces: creation, preservation, and destruction.

In middle-income countries, these forces manifest in the following ways:

• Forces of creation are the primary engine of growth – but often the weakest. Large incumbents innovate slowly, and most SMEs enter markets but don’t innovate or disrupt.

• Forces of preservation dominate. Large incumbents are often effective at maintaining dominance and resisting change.

• Forces of destruction – a necessary evil to make way for renewal – are suppressed by weak institutions and poor policy.

“Incumbents” refers to dominant private or state-owned firms and social elites.

The report then examines each of these forces and outlines strategies to balance them.

Forces of Creation

It is widely believed that new entrants drive innovation, while incumbents seek to protect their position. Startup success stories feed this perception.

However, in many middle-income countries, the inertia of both incumbents and new entrants challenges the conventional notion of creative forces. Large firms often reach scale due to market distortions, not efficiency. They then entrench themselves politically to preserve that advantage.

New entrants tend to start businesses out of necessity, not by identifying entrepreneurial opportunities. As a result, most firms remain microenterprises that neither grow nor exit the market — and thus contribute little to productivity growth.

This suggests that the issue is not market power per se — incumbents can either block or drive creative forces. Their scale gives them an advantage: they can invest in better products, attract and reward skilled workers, and deploy large volumes of capital efficiently. Even in innovation, the lead actors over the past 150 years have shifted from garage inventors to the R&D units of modern corporations.

In truth, the problem lies in the quality of the institutional environment. Market power becomes problematic when a weak institutional setting creates the following conditions:

• it is not based on innovation but on political connections;

• it is protected by government intervention;

• it is upheld through illegal strategic behavior.

In many middle-income countries, there is a tendency to support entrepreneurship based on firm size. In effect, governments end up taxing value creation and productivity gains. As a result, efficient firms often remain smaller than their technical potential would allow, while unproductive ones grow larger than they should.

It is therefore crucial that value-creating firms – regardless of their size – are able to expand, hire more workers, and replace enterprises that fail to generate additional value. This ensures that capital and labor are not trapped in inefficient firms but instead are reallocated to more dynamic ones. Notably, 50–70% of productivity growth comes from the successful reallocation of resources across firms – both new entrants and incumbents.

Forces of Preservation

The quality of human capital matters more in middle-income countries than in low-income ones due to the increasing complexity of the economy and the need to transition toward active innovation.

Yet many face talent shortages, worsened by preservation forces that suppress new talent and waste existing potential, restricting social mobility.

Three drivers of preservation are highlighted:

• Social networks that isolate groups, devalue talent, and entrench inequality.

• Neighborhoods that trap people, block knowledge diffusion, and hinder small business scaling.

• Norms that marginalize vulnerable groups in education and employment.

The main policy antidote is quality education.

Forces of Destruction

Crises are a necessary evil, as they weaken the forces that preserve the status quo and push economies toward restructuring and resource reallocation.

A notable example is the impact of the 1997 Asian financial crisis on South Korea. The external shock exposed deep structural weaknesses in an economy dominated by family-owned conglomerates, or chaebols, which had grown through excessive debt financing and predatory practices that crowded out competitors. As a result, when the crisis triggered the collapse of 15 of the 30 largest chaebols, the government was compelled to reform both the corporate system and the financial sector. This, in turn, unlocked the potential of firms backed by venture capital and fueled rapid growth in the information and communications technology (ICT) sector.

The climate crisis agenda promoted by advanced economies is a timely example of such a turning point. Today’s energy transition in developed countries is reshaping the global landscape of trade and industrial policy, disrupting the coordinated trade environment of the past 30 years. In particular, industrial policies in high-income countries increasingly incorporate local content requirements and other reshoring efforts to support their own industries.

As a result, today’s middle-income countries must navigate a more complex global context, where core trade rules remain unsettled.

These countries now risk falling behind – not because of the expansion of low-carbon technologies or the phaseout of fossil fuels per se, but due to:

• outdated policies and practical rules that constrain value-creating firms and protect unproductive ones;

• limited improvements in human capital and labor mobility;

• a reluctance to loosen state control over productive assets.

Balancing Strategy: Disciplining Incumbents

As described earlier, incumbents can both hinder and enable progress. Disciplining them requires a dual approach: supporting the growth of market leaders while preventing the abuse of their dominant positions. This makes the creation of contestable markets essential – environments where incumbents, under the constant threat of being replaced by more efficient domestic or foreign competitors, are motivated to improve their products and processes.

Such market contestability is a cornerstone of creative destruction and is cultivated through a combination of three types of policies:

1. Institutions that weaken the forces of preservation;

2. Incentives that strengthen the forces of creation;

3. Interventions that target errant incumbents to destroy harmful arrangements.

Interventions are only effective when supported by enabling institutions and a well-aligned system of incentives. However, in many middle-income countries, institutional inertia tends to shield incumbents and entrench preservation forces, resulting in low turnover among market leaders and limited dynamism.

To overcome this, policymakers in middle-income countries should recalibrate their strategies, beginning with the strengthening of institutions that curb anti-competitive preservation, followed by the realignment of incentives to reinforce creative forces.

Specifically, policymakers should phase out direct state involvement in commercially viable activities, and dismantle outdated regulatory frameworks (e.g., licensing regimes or legacy product standards) that disproportionately benefit incumbents and raise entry barriers.

Regarding the first, public ownership and associated weak governance represent a significant barrier to entry. Empirical evidence indicates that doubling the state’s market share in a given sector is associated with a 5–35% decline in new firm entry.

As for the regulatory environment, rules should be assessed not only for compliance and control, but also for their contribution to product or service quality. Notably, in high-income economies with stronger institutional environments, product market regulations (PMRs) tend to be less distortive and more performance-oriented compared to those in developing countries.

Finally, building incentives that strengthen creative forces requires open product markets that facilitate the absorption and diffusion of advanced know-how. As emphasized in WDR 2024, international trade plays a critical role — by providing access to larger markets, global value chains, and cutting-edge technologies, while also exposing firms to competition from those closer to the technological frontier.

Hence, incentive frameworks in middle-income countries should prioritize linkages between global and domestic firms and support the adoption of modern organizational practices.

Balancing Strategy: Rewarding Merit Activities

To strengthen the forces of creation, middle-income countries must reorient their policies and institutions toward promoting merit-based activity – that is, economic behavior that generates positive social value and ensures the efficient use of talent, capital, and energy.

Specifically, middle-income countries should put three considerations at the center of economic policy making:

1. The economic and social mobility of people,

2. The value-added by firms,

3. The greenhouse gases emitted by the economy.

The economic and social mobility of people:

Governments should adopt policies that promote the efficient allocation of talent – particularly by expanding open access to education, employment, and entrepreneurial opportunities. The goal is not perfect income equality but equal opportunity. A system that rewards merit can generate higher levels of both social and economic mobility, accelerating growth. What matters is the perception of mobility: when people believe upward mobility is possible, societies tend to be more tolerant of inequality.

A key channel for promoting social mobility is the continual renewal of the talent pool, enabled through improvements in the education system. In many middle-income countries, this involves navigating trade-offs between investing in foundational skills and more specialized capabilities.

One approach is progressive universalism in education spending – as applied, for example, in the Republic of Korea in the 1950s. “Universalism” refers to the commitment to high-quality education for all, while “progressive” reflects the need to prioritize limited resources by focusing first on early learning and inclusion. Under this principle, countries expand investment in higher levels of education only after achieving universal foundational quality at the early stages.

Importantly, improving foundational learning does not always require higher spending, but it does require more effective use of resources. Cross-country evidence shows that higher education budgets do not necessarily translate into better learning outcomes.

The value-added by firms:

Entrepreneurship in middle-income countries often diverges from the principle of rewarding merit. Subsidies for small and medium enterprises (SMEs) are widespread and typically aim to promote firm growth and job creation.

However, such subsidies can distort incentives by discouraging expansion and scaling. As a result, many firms choose not to grow.

This reflects underlying weaknesses in the competitive environment, often shaped by fears of displacement by larger firms. Unconditional support for small enterprises can reduce the exit of unproductive firms, reinforce subscale operations, crowd out other businesses, and misallocate resources.

To support SME growth, targeted programs should focus on identifying firms facing genuine constraints to scale and productivity, and on removing those specific barriers. Doing so requires robust data systems, strong analytical capacity, and a shift in focus – from protecting small firms to enabling productive firms to grow.

The greenhouse gases emitted by the economy:

In light of the global decarbonization agenda, policy debates in middle- and high-income countries should focus on decoupling GDP growth from emissions growth. Given the pace of progress toward environmental goals, efforts should prioritize reducing path dependence in energy systems while strengthening natural resource protection.

Among economists, carbon pricing—whether through carbon taxes or emissions trading systems (ETSs) – is widely regarded as the most growth-compatible and cost-effective approach to emissions reduction. However, adoption of direct carbon pricing mechanisms remains limited across countries.

To incentivize emissions reduction on the supply side – particularly by scaling access to clean energy – one of the most effective tools is implementing the merit order principle for grid operators. This principle requires wholesale energy prices to be determined by the lowest-cost supply, which favors renewable energy given its low marginal costs.

However, for the merit order system to function effectively, robust regulatory frameworks must ensure open market access and prevent anti-competitive behavior.

Balancing Strategy: Capitalizing on Crises

A promising pathway for developing countries to adapt to the global decarbonization agenda is integration into global green value chains – particularly by supplying intermediate goods for low-carbon technologies. Four such technologies – solar photovoltaic panels, wind turbines, lithium-ion batteries, and electrolyzers for green hydrogen – exhibit learning curves, with costs declining as deployment scales up.

To reduce the energy intensity of the economy, governments can support the adoption of energy-efficiency technologies in energy-intensive firms, including through targeted financial incentives.

To develop domestic markets for low-carbon technologies, governments should: phase out subsidies for fossil-based technologies, support investments in transmission infrastructure, and adopt standards to enable interoperability across energy sources.

The report offers a clear and accessible framework for analyzing development dynamics in middle-income countries and outlines a coherent logic for policy action. A recurring theme is the centrality of institutions – they are key to unlocking the forces of creation, constraining preservation, and enabling constructive disruption. This highlights the need for systemic economic settings and calls for a nonlinear approach to policy and reform.

Business dynamism, for instance, should not be narrowly defined as support for micro and small enterprises. Instead, the focus must be on creating conditions that enable all firms to realize their creative potential.

Another core message of the report is the importance of reform sequencing. A modern, innovation-driven economy cannot emerge without first establishing solid foundations – institutional capacity, technological upgrading, and steady investment in human capital.

The report presents Poland as an illustrative case. Following its transition from a planned to a market economy, Poland’s per capita income rose from 20% to 50% of the European Union average. Its success lay in the orderly and logical sequencing of reforms. The government began by disciplining incumbents – tightening budget constraints on large state-owned enterprises through subsidy cuts, restricted access to credit, and trade liberalization. These steps laid the groundwork for deeper structural reforms. Enterprise managers shifted their focus from output targets to profitability and market share, thereby enhancing firms’ capabilities ahead of privatization. This sequence of reforms allowed Poland to attract investment, absorb technology from Western Europe, and transition toward innovation-led growth.