Industrial policy for services sector productivity

We live at a time when the labour intensity of manufacturing is decreasing and even the limited lower-tech manufacturing jobs are disproportionately concentrated in China. Besides, manufacturing itself appears to be on the path to becoming more services-intensive. 

All this coupled with the general dominance of the services sector in the economy (in India it contributes 55-60% of GDP, compared to 12-14% of GDP for manufacturing) means there’s a strong argument that the future will become even more services-dominated and services will drive productivity growth. Accordingly, in recent times, there have been several influential voices demanding a focus on services as the driver of economic productivity and growth. 

But this sits with the reality that high productivity and tradeable services jobs are mainly in the knowledge-based sectors, which comprise only a small proportion of the labour force (India’s $250 bn IT sector employs just 5.5 million people). The vast majority of services sector jobs, which form the dominant source of employment in developing countries, run into the problem of low productivity. 

So, what can industrial policy do to address this problem? 

Before we examine this issue, it’s useful to look at the challenge of productivity improvements in the services sector. 

Our concern is with widely varying services sector occupations like haircuts, retail shop floor services, construction and related services, drivers, janitors, housemaids, cooks and waiters, security guards, lawyers, accountants, data entry operators and so on that serve the mass market (not the high-income consumers or serve the large firms). They make up not only the vast majority of the services sector workers but also the aggregate new jobs creation. 

Consider the following:

1. The tradeability of manufactured goods, within and outside the country, is a critical source of its competitiveness and productivity. However, unlike manufacturing, given its general non-tradeability, there’s no possibility of globalised market competition in the vast majority of the services sector. In fact, the vast majority of mass-market services serve small localised markets. This means that the services sector must look for alternate channels to drive productivity improvements. There may even be a case for industrial policy to guide services sector productivity growth. 

2. Apart from their low tradeability, good quality services sector jobs are skills-biased. This means that there will be hard limits and constraints to both demand and supply of those jobs. It should be noted that the entire IT services sector employs less than 0.1% of India’s 565 million workforce. While there are no good estimates, I would imagine the higher-skilled services employ no more than 1-2% of the workforce. This low base cannot be the driver of technology and productivity spillovers and diffusion across the economy, nor become the driver of broad-based economic output expansion. In contrast, manufacturing occupies 11.4% of the workforce.

3. Further, unlike manufacturing, the productivity of the services sector is intimately linked to the country’s per capita GDP. Lower-income countries have the majority of their employment and a very high share of their output in the informal sector, where productivity is low. There’s an endogeneity to this - low incomes reduce purchasing power, thereby confining consumption affordability to the informal sector where prices are lower. 

If you consider the high share of the services sector in the economic output, the large informal sector employment arising from the low incomes and attendant consumption affordability, and the generally low productivity of the informal sector, there’s a real productivity (and thereby output growth) challenge that developing countries like India that are reliant on the services sector will face. A low-income country can grow rapidly by becoming a manufacturing powerhouse for textiles or toys or footwear and exporting them, but there are limits to growth through the production of the globally competitive services sector jobs we’re interested. 

4. The market dynamics cannot do much to increase the productivity of these informal markets. Many of these informal markets are perhaps more competitive and dynamic than their formal sector counterparts. But at low price levels, there is only so much capital investment and productivity improvement that is possible. The real binding constraint is affordability, and this constraint is relaxed only gradually and that too with economic growth. 

This brings us to the question of what governments can do to address productivity in the services sector. 

In the latest Union Budget, the Government of India announced a new skilling scheme that seeks to provide one-year internship opportunities to 10 million youth by 500 top companies over the next five years. The interns would be paid a one-time allowance of Rs 6000 by the government and a monthly stipend of Rs 5000, of which the Government would pay Rs 4500 and the companies could tap into their Corporate Social Responsibility (CSR) funds for the remaining Rs 500. The participation by companies is purely voluntary. The objective is to provide exposure to “real-life business environment and varied professions”, and there’s no obligation for the companies to hire them subsequently. 

In simple terms, this scheme tries to provide a learning-by-doing employability skills acquisition opportunity for new workforce entrants. It’s hoped that by being part of the industrial ecosystem, these interns would have acquired some skills that increase their employability. It’s a good idea but its success will depend on its uptake and quality of internship. There should be some patience with the implementation of such ideas - the design will have to undergo iteration and the uptake will be non-uniform. There’s likely to be plenty of abuse of this scheme. Since companies anyways must spend their CSR funds, their stake in this scheme will be a function of the value they see in the interns. It’s therefore important that at least some of the industry becomes invested in the scheme. It should be framed as the industry’s contribution as a partner in the economic growth of the country, and only those genuinely interested companies should be allowed to participate in the scheme. 

Another approach is through the provision of management extension services. This includes supporting small businesses to improve their management practices - managing and monitoring operations, managing finances, and managing human resources. Apart from their impact on the productivity of the firm itself, it also has strong spill-over effects. There’s a rich body of evidence that points to the value of such services. The positive externalities highlight the public goods nature of such investments. In my co-authored paper on job creation in India published by Carnegie Endowment, we have described the details of such management extension services. 

Governments could enlist consultants and service providers and offer to bear a share of the service fees. The extent of the subsidy could vary, depending on the nature of the service and be restricted to firms younger than five years (with a higher subsidy reserved for the youngest firms), thereby aligning the incentives of the firms and their service providers. This support could also be further restricted to younger firms alone and for two to three years only. It could even be designed to recover the subsidies (once the enterprises have succeeded), either directly or as part of a tax collection scheme.

Another idea could be to make available easily customisable, user-friendly, and highly versatile productivity improvement tools as public goods. Good examples on the digital side would include making freely available software (on smartphones, tablets, and desktops) for inventory management, financial accounting, work monitoring, and so on. These could be customised for the specific requirements of mom-and-pop establishments and small firms across a variety of broad sectors. On the individual learning side, there could be a public supply of self-learning Apps and modules for generalised (within the firms in a specific industry) and cross-cutting (across industries) learning and skills. 

Industrial policy could support industry associations (or groups of large private companies in an industry) to develop these tools. These solutions could also be provisioned by the market at reasonable prices and the government could heavily subsidise their access. The theory of change with the adoption and effectiveness of these solutions will be very non-uniform and complex. 

In this context, in a new working paper, Dani Rodrik argues that since manufacturing is unlikely to absorb the large new additions to the labour force and that urban jobs are predominantly informal, unproductive, and in services, there’s a need to raise the productivity in services to achieve long-term growth. He proposes four ideas - incentivise large, productive firms to expand their employment; enhance productive capabilities of smaller firms through the provision of public inputs (like management training, loans or grants, customised worker skills, specific infrastructure, or technology assistance); provide workers or firms technologies that explicitly complement low-skill labour; and vocational training with “wrap-around” services to enhance employability and career progression. 

However, all these ideas have severe limitations in their effectiveness for at least two reasons. One, given the ubiquitous state capability weaknesses, even with the best program design, they’ll struggle to be implemented with fidelity. Unless demand-driven (by the internship-seeking youth and the internship-offering firms), they are likely to flounder. And demand will come from demonstration of value, for both the interns and the employers. This, in turn, will take time and the emergence of demonstration successes. They cannot be forced into realisation through targets and timelines.

Second, there are two parts of the employability challenge - education and skills. While internships and training can help bridge the latter, such short engagements can do little to address large antecedent education lags. It’s impossible to compress the learnings of 10 or 12 years of schooling into a few months of internship or training. 

This brings us to the real challenge of productivity, especially relevant to the services sector. The foundations of economic productivity are laid in the quality of education available. This again underscores the importance of quality of schooling and the realisation of learning outcomes. It assumes greater significance in the context of an economy where the vast majority of jobs will be created in the services sector, and that too in the informal market. 

We need to bear in mind that even if all these efforts succeed spectacularly, for all the reasons discussed earlier, the services sector has its limitations in boosting incomes significantly and that too in the broad-based manner required to raise output. That might happen only with manufacturing and exports.