Overcoming the middle-income trap: Why institutions matter

Many middle-income countries (MICs) aspire to achieve high-income status, yet only a few succeed. Since 1990, just 34 countries have made this transition. Today, 108 nations are classified as “middle-income,” with annual per capita incomes between $1,100 and  $13,800. These countries generate nearly 40 percent of global economic output and are home to more than 60 percent of the world’s extreme poor. Their progress will shape the future of global growth and poverty reduction.

Two recent studies on institutions and growth in MICs and the state’s role in middle-income to high-income transitions in Europe & Central Asia identify key policy lessons for non-resource rich countries aiming for high-income status. The challenge, we argue, is not merely a lack of capital, infrastructure, or trade opportunities, but the absence of institutions that incentivize and sustain the right investments and policies as economies mature.

Why many MICs stall: The political economy of middle- to high-income transition

The “middle-income trap” is fundamentally an institutional trap where incremental reforms and weak institutions that delivered early growth are no longer sufficient :

• Innovation trumps imitation, but requires clear rules. For low-income growth, factor accumulation and technology catch-up can occur even with subpar rule of law or control of corruption. But moving towards high-income status requires sustained innovation, driven by reliable business environments, fair competition, and strategic and efficient public investments in research, infrastructure and education. In short, effective and mature institutions are essential for fostering innovation.
• Incumbents resist new rules and need to be incentivized and disciplined: Deepening competition threatens established benefits, so elite coalitions often oppose reforms. Without transparency and credible enforcement, incumbents can capture or dilute the economic policies needed to support the transition - a situation known as the political economy trap. Successful countries disciplined incumbents and incentivized them to contribute to growth rather than protecting their own interests and rents.
• Trust is instrumental: Citizens’ tax compliance and firms’ investments depend on institutional trust, which is contingent on transparent, fair and predictable rules. Without trust, achieving high income is slowed or derailed due to recurrent conflicts and crises.

What do countries that have escaped the middle-income trap have in common?

We identify two core institutional characteristics often present in non-resource rich countries that successfully “escape” the middle-income trap:

1. A strategic and adaptive state - The strategic state is not necessarily a big state but a smart, autonomous, and adaptive one: It must steer markets, manage innovation risks, and shape incentives - yet remain protected from capture. In the Europe and Central Asia (ECA) region, both converging and stagnant countries tend to have large public sectors. But convergers allocate public spending to infrastructure and human capital, and their state institutions successfully shifted from controlling key economic sectors to creating enabling frameworks such as protecting competition, building regulatory capacity, and investing in public goods. These states  became “enablers” rather than “controllers”.
2. Improving rules and institutions alongside economic growth - ECA convergers often started with imperfect institutions but steadily improved rule of law, checks and balances, and administrative integrity over time. The strongest predictor of convergence was sustained improvement in the rule of law — not just laws on paper, but their consistent, impartial enforcement. These institutions were not built overnight: institutional improvements are gradual but cumulative.

Conversely, where institutions fail, trust declines, hindering  competition, investments, and innovation. Low  trust leads to reliance on personal relationships and informal deals to navigate bureaucracy, stifling fair competition and discouraging risk-taking.

Institutions are critical for sustaining the middle-to-high income journey

Drawing from both papers, here are five imperatives that should guide any country trying  to overcome the middle-income trap:

1. Diagnose political constraints, not just policy gaps. Effective reforms require understanding benefits and costs distribution, stakeholder incentives, and the coalitions that may facilitate or hinder change.
2. Invest in autonomous, strategic state capacity. Ministries of economy, planning, industry, and innovation must be able to operate with credibility, performance incentives, and reduced political capture.
3. Manage public support smartly. A shift from broad giveaway policies to performance-based, selective rewards like innovation grants and R&D subsidies can help align private incentives with public goals, while limiting rent-seeking by incumbents.
4. Earn and sustain trust. State interventions must become fair, predictable, and transparent. Mechanisms to widen participation and enforce anticorruption, help transform compliance from coercion to voluntary.
5. Treat crises as opportunities. Economic or political shocks often weaken entrenched interests, making it easier to implement reforms with strategic leadership. In ECA, countries that enacted major changes during downturns — such as in the 1990s transition and after the global financial crisis—gained credibility faster.

At its core, the middle-income to high-income transition hinges on institutional reform. While structural policies (macroeconomic, trade, infrastructure) are important, they  become transformative when paired with stronger institutions. As noted in the two World Bank papers,  institutional quality is central—not secondary— to growth in MICs.