Growing Like India—the Unequal Effects of Service-Led Growth

Tianyu Fan, Michael Peters, and Fabrizio Zilibotti illustrate how service-led growth can be a viable development strategy for the developing world; however, its fruits might disproportionately benefit the rich. Read the full paper, originally published in Econometrica, here. This article first appeared in VoxDev.

The structural transformation of industrialised countries has historically been remarkably similar across the world. In early stages of development, a growing industrial sector drew labour from a declining agricultural sector, and at a later stage, the employment shares of both agriculture and manufacturing decreased, while services — which included employees like janitors, grocery store clerks and accountants — became the main source of employment growth (Herrendorf et al. 2014).

While this pattern fits the historical experience of most Western and East Asian economies fairly well, today, the economic development in most developing countries appears to be taking a different path. In fast-growing economies like India and several countries in sub-Saharan Africa, the share of manufacturing jobs has barely grown and the structural transformation has shifted employment straight from agriculture to services.

Figure 1 displays this pattern for India between 1987 and 2011 — a period during which income per capita increased by a factor of almost three. While the agricultural employment share declined substantially, manufacturing employment was entirely stagnant and the service sector (and to a lesser extent, the construction sector), absorbed the workforce leaving the fields.

This pattern of "premature de-industrialisation" (Rodrik 2016) is a cause of concern to many scholars. Technical progress in manufacturing is traditionally seen as the main engine of growth and an expanding service sector might be a pale substitute. Indeed, the growth of the service sector is for many a mere corollary of economic development, whereby rising incomes increase the demand for services.

Can the service sector then also be a source of productivity growth per se, and hence present a viable development strategy for today’s developing world? In our recent study on service-led growth in India (Fan, Peters and Zilibotti 2021), we conclude that economists and practitioners might be overly pessimistic about such a possibility. Using a new methodology that allows us to infer productivity growth from micro data on employment, wages, and human capital, we document that productivity growth in the service sector has been substantial and can account for about one third of aggregate welfare gains since the late 1980s. However, such productivity gains were strikingly unequal and benefitted particularly rich consumers living in cities.

The service sector in India: Consumer and producer services

Any attempt to measure productivity growth in the service sector faces two important challenges. First, in many service industries, it is difficult to estimate total factor productivity. Second, the service sector encompasses a range of very heterogeneous activities; indeed, retail workers, consultants, IT specialists, and domestic housekeepers are all classified as service workers. 

In our approach, we distinguish between different types of services according to the nature of the typical buyer and whether the value added created by such services is tradable. On one end of the spectrum are retail employees whose services are non-tradable and almost entirely demanded by local consumers. We dub these services consumer services. On the other end are corporate lawyers and ICT workers who often cater to other firms. We call these producer services; they are akin to intermediate inputs and their value added is tradable. 

Figure 2 shows how the employment share in these different activities has evolved over time and varies between rural and urban districts in India. Three patterns are noteworthy. First, employment increased in all service activities. Second, services are particularly concentrated in cities. While this “urban bias” is especially pronounced in producer services like ICT or the provision of financial services, it is also apparent in traditional consumer service categories like retail and hospitality. Third, even though India is often hailed as a producer service hub with its call centres and expertise in ICT, consumer services still comprise the lion’s share of its service sector.

At first glance, this might look like evidence in support of the pessimistic view. Indeed, there may be technical progress in the financial sector, but what about the wholesale and retail industries? However, before drawing any conclusions, it might be worth noting that recent research argues that even in the US, the expansion of high-productivity firms in the retail sector has been an important source of growth (Hsieh and Rossi-Hansberg 2020).