Governments around the world pour billions into subsidies that incentivize domestic production in specific industries, including in developing economies. For instance, in 2023, leading players in China's semiconductor industry received subsidies amounting to US$2.82 billion in 2023. Similarly, India’s production-linked incentive scheme has allocated roughly $25 billion dollars over 5 years to sectors such as automobiles and components, mobile phones and components, pharmaceuticals and ingredients, advanced cell batteries, and telecom. Cross-country evidence shows that trade-distortive subsidies — provided through state loans, tax relief, capital injection, state aid, and financial grants — are the most frequently used industrial policies and account for more than one-third of all industrial policies in developing economies (Figure 1). What is the underlying rationale for their use? What improves the likelihood of their success? And what are possible alternatives?
Underlying rationale
The infant industry argument often constitutes the underlying rationale for sector-specific production subsidies. Smaller firms or potential market entrants in developing countries may struggle to compete against larger incumbent firms from more advanced economies due to economies of scale. Ideally, smaller or nascent firms with good business plans should be able to secure credit from financial markets to finance the necessary investments. However, credit market failures in developing countries often constrain such lending, making production subsidies a second-best solution to address these failures.
The case for infant industry protection can be assessed through the “Mill-Bastable” test, named after famous economists, John Stuart Mill and Charles Bastable. This test includes three criteria:
- Dynamic Learning-by-Doing Effects: The industry must exhibit learning-by-doing effects that are external to firms, constituting a market failure where firms do not internalize the benefits that spill over to other firms and industries.
- Viability Without Protection: The industry must mature over time and become viable without protection, requiring a rise in demand, particularly foreign demand for exports.
- Cumulative Benefits versus Costs: The cumulative benefits of protection must exceed the cumulative costs.
An emerging literature provides empirical evidence for some of these criteria in the context of production subsidies. For example, case studies based on firm-level data, such as those for the shipbuilding and semiconductor industries, estimate learning-by-doing effects (Goldberg et al. 2024, Barwick et al. 2024).
Conditions that improve the likelihood of success
While the “Mill-Bastable” test might be hard to consistently apply in practice, rules of thumb and metrics based on aggregate data can guide the use of production subsidies:
- Demand Growth: The costs of incentivizing production through subsidies or tax breaks can only be recovered if the industry experiences an increase in demand for its goods, particularly in foreign markets (Goldberg and Reed 2023). Export markets also impose price and quality discipline on producers.
- Comparative Advantage: The interplay between growing markets and patterns of comparative advantage can assess the risk of targeting specific industries. Targeting industries with growing markets and technological relatedness is less risky than targeting industries without technological relatedness (Reed 2024).
- Policy Coordination and Consistency: The effectiveness of production subsidies depends on complementary investments and regulatory changes targeted at the same industry. For example, production subsidies and tax holidays in China positively impacted firm productivity when directed at competitive industries (Aghion et al. 2015). Similarly, tax holidays in the Republic of Korea during the 1970s, combined with duty-free access to intermediate inputs, resulted in export gains and downstream industry expansion (Lane 2022).
Alternatives to Production Subsidies
Production subsidies reduce current production costs, whereas investment subsidies reduce future production costs too. It can therefore be cheaper in the long run to subsidize investment rather than production, as evidenced in China’s shipbuilding industry (Barwick et al. 2024). However, all subsidies are costly. Import tariffs can protect infant industries while raising government revenue but impose additional distortions on consumption by raising prices.
Industrial development banks can directly address credit market failures constraining lending to nascent firms and industries. Concessional loans may not be cheaper than production subsidies, but financial intermediaries can “pick” winners through experimentation and evaluation. For example, large-scale national business plan competitions in Nigeria identify and spur high-growth entrepreneurs (McKenzie 2017). Effective insolvency regimes can evaluate entrepreneurial failure and reduce capital sunk in zombie firms (McGowan, Andrews, and Millot 2017). However, industrial development banks have faced numerous failures with questionable lending practices, and losses. Their role needs reimagining, drawing on their unique vantage point for observing market and government failures (Fernández-Arias, Hausmann, and Panizza, 2020). Government capabilities and institutional quality are crucial in this context.
Conclusion
In principle, production subsidies can support infant industries. In practice, their success depends on various factors, including demand growth, comparative advantage, and policy coordination. Alternatives like investment subsidies and industrial development banks offer different advantages and challenges. As we look to the future, the effective implementation of production subsidies as industrial policy requires careful consideration of market dynamics, government capabilities, and institutional quality.
This is the second blog in the World Bank’s Prosperity Vertical’s Chief Economist’s Office Chat-IPT (Industrial Policy Talks) series. The inaugural blog: The double-edged sword of export bans on critical metals explored the impact of restrictions and bans on exports of critical metals for the world's green transition and their economic trade-offs for developing countries.
References
- Aghion, Philippe, Jing Cai, Mathias Dewatripont, Luosha Du, Ann Harrison, and Patrick Legros. 2015. "Industrial Policy and Competition." American Economic Journal: Macroeconomics, 7 (4): 1–32.
- Barwick, Panle J., Myrto Kalouptsidi, and Nahim B. Zahur. 2024. “Industrial Policy Implementation: Empirical Evidence from China’s Shipbuilding Industry”, Forthcoming Review of Economic Studies.
- Evenett, Simon, Adam Jakubik, Fernando Martín, and Michele Ruta, 2024. "The Return of Industrial Policy in Data," IMF Working Papers 2024/001, International Monetary Fund.
- Fernández-Arias, Eduardo, Ricardo Hausmann, and Ugo Panizza, 2020. "Smart Development Banks," Journal of Industry, Competition and Trade 20(2): 395-420.
- Goldberg, Pinelopi K., Réka Juhász, Nathan J. Lane, Giulia Lo Forte, and Jeff Thurk. 2024. “Industrial Policy in the Global Semiconductor Sector”. NBER Working Paper No. 32651, National Bureau of Economic Research, Massachusetts.
- Goldberg, Pinelopi K., and Tristan Reed 2023. “Presidential Address: Demand Side Constraints in Development: The Role of Market Size, Trade, and (In)Equality”, Econometrica 91(6): 1915-1950.
- Nathan Lane, 2022. "Manufacturing Revolutions: Industrial Policy and Industrialization in South Korea, Accepted Quarterly Journal of Economics.
- McKenzie, David. 2017. "Identifying and Spurring High-Growth Entrepreneurship: Experimental Evidence from a Business Plan Competition." American Economic Review, 107 (8): 2278–2307.
- McGowan, Müge Adalet, Dan Andrews, and Valentine Millot. 2017. "Insolvency Regimes, Zombie Firms and Capital Reallocation," OECD Economics Department Working Papers 1399, OECD Publishing.
- Reed, Tristan. 2024. “Export-Led Industrial Policy for Developing Countries: Is There a Way to Pick Winners?” Forthcoming Journal of Economic Perspectives.
This is the second blog in the World Bank’s Prosperity Vertical’s Chief Economist’s Office Chat-IPT (Industrial Policy Talks) series. The inaugural blog: The double-edged sword of export bans on critical metals explored the impact of restrictions and bans on exports of critical metals for the world's green transition and their economic trade-offs for developing countries. The third blog: Is there a way to do industrial policy without strong institutions? showcases the emerging evidence showing that public-private dialogue is potentially one way to develop the institutions required for effective industrial policy.
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