The Agricultural Sector And Economic Growth

Because higher productivity in farming can release labor for other sectors, for several decades of the twentieth century this relationship between agriculture and overall economic growth became distorted into a doctrine of pursuing industrialization even at the expense of agricultural development, with the result of undercutting agriculture's possibilities of contributing to overall development. The sector was viewed as playing a supporting role to industrial development, which was considered the most essential aspect of a growth strategy. In fact, industry was thought to be so important to a nation's long-run economic prospects that it was common practice

2. Editors of Time-Life Books, The Rise of Cities, Time-Life Books, Alexandria, VA, USA, 1990, p. 7.

3. D. Gale Johnson, 'Agriculture and the Wealth of Nations', Richard T. Ely Lecture, American Economic Association Papers and Proceedings, American Economic Review, 87(2), May 1997, p. 2.

4. Adam Smith, An Inquiry into the Nature and Causes of the Wealth of Nations, Modern Library Edition, New York, 1937, p. 37 (cited in D. G. Johnson, 1997, p. 2).

to subsidize it, at the expense of taxpayers and other sectors.

This was the doctrine of the first generation of economic development strategies. The practice of favoring and subsidizing industrial development was especially pronounced in Latin America and some countries of Asia. Perhaps the best-known early Latin American exponent of that tradition was Celso Furtado. In words that have an odd ring today, Furtado said, regarding sectoral priorities in Brazilian development:

Government action as a source of ample subsidies for industrial investments through foreign exchange and credit policy permitted the expansion, acceleration and broadening of the industrialization process. Without the governmental establishment of basic industries (steel, petroleum) and without the foreign exchange subsidies and the negative interest rates of government loans, industrialization would not have achieved the speed and the breadth that evolved during that quarter of a century.6

In this approach to development, the role of agriculture was seen as that of a provider of 'surpluses' (of labor, foreign exchange and domestic savings) to fuel industrial development. It was not looked to as a source of income growth in its own right. On the contrary, the implementation of subsidies for industry meant levying a tax, implicit or explicit, on agriculture which was likely to depress its growth prospects. Furtado commented in another context that in Mexico:

. .. since 1940, agricultural policy has systematically pursued the objective of increasing the agricultural surplus extracted for urban consumption or export.7

This vision of the limited role of agriculture in economic development was not confined to Latin American economists. It was a central part of the 'dual-economy model' of John Fei and Gustav Ranis.8

Anne Krueger summed up the early thinking in development economics as containing:

several prevalent and dominant strands . .. : (1) the desire and drive for 'modernization'; (2) the interpretation of industrialization as the route to modernization; (3) the belief in 'import substitution' as a necessary policy to provide protection for new 'infant' industries; (4) the distrust of the private sector and the market and the belief that government, as a paternalistic benevolent guardian, should take the leading role in development; (5) related to (4), a distrust of the international economy and pessimism that exports from developing countries could grow.9

While not calling for subsidies to industry, Hollis Chenery and Moises Syrquin emphasized that agriculture should be expected to provide transfers of capital as well as labor to urban areas to promote the general development of the economy.10 Even agricultural economists have subscribed to this thesis in the past:

6. Celso Furtado, Obstacles to Development in Latin America, Anchor Books, Doubleday and Company, New York, 1970, p. 144.

7. Celso Furtado, Economic Development in Latin America, 2nd Edn, Cambridge University Press, Cambridge, UK, 1976, p. 259.

8. John C. H. Fei and Gustav Ranis, Development of the Labor Surplus Economy: Theory and Policy, Irwin Publishing Company, Homewood, IL, USA, 1964.

9. Anne O. Krueger, 'Policy Lessons from Development Experience since the Second World War', in J. Behrman and T. N. Srinivasan (Eds), Handbook of Development Economics, Vol. IIIB, North-Holland Publishing Company, Amsterdam, 1995, p. 2501.

10. Hollis Chenery and Moises Syrquin, Patterns of Development, 1950-1970, published for the World Bank by Oxford University Press, London, 1975.

.. . agriculture must provide major increases in agricultural production, but it must also make significant net contributions to the capital needs of other sectors of the economy. . .

and:

The contribution of the rural sector to capital formation may be marshaled. . .. through the medium of taxation.. . . [and through] a relative decline in agricultural prices. .. . Taxes are most easily levied on export crops12

Today, agricultural policy makers often struggle to arrest declines in real agricultural prices and profitability. In addition, it is now recognized that commodity-specific taxes reduce the sector's growth prospects, not only by causing reductions in the profitability of investment and production, but also by distorting the allocation of resources among commodities.

Bruce Johnston and John Mellor developed a more complete vision of the agricultural development process and advocated policies that favored development of the smallholder sector. Theirs was the first agricultural development strategy to emphasize the importance of increasing productivity, even among smallholders. They described a long-term growth process in which the type of technological innovation varies by phase of the process. Nevertheless, their view of agriculture's role was to support the development of the other sectors in the economy, mainly by supplying goods and factors of production to the rest of the economy. That role includes supplying labor, foreign exchange, savings and food to the economy, as well as providing a market for domestically produced industrial goods.13

Therefore, far from advocating support for agriculture, much of the thinking in the past 50 years about agriculture's role in development advocated taxing the sector, directly or through pricing policies, to provide resources for the development of the rest of the economy, and in some cases using the resultant resources to subsidize industry. Among other concerns that would be raised today about this approach, a basic question is how far can agricultural incomes be reduced by pricing and taxation mechanisms before rural poverty reaches unacceptable levels and agricultural production stagnates for lack of profitability?

Until recently, the success of East Asian economies reinforced, for many observers, the conviction that industrialization was the route to the creation of national wealth, and it contradicted the earlier pessimism about the possibilities of export expansion in developing countries. Over the years a discussion has been carried on regarding the extent and success of government interventions to promote the industrial sector in the East Asian economies, with divergent conclusions. An exhaustive analysis of that experience by a World Bank team concluded that industrial credit subsidies sometimes (but not always) contributed dynamic benefits to the industrialization process in those countries, and that subsidies for exports were more successful in that regard:

Whether these interventions contributed to the rapid growth made possible by good [policy] fundamentals or detracted from it is the most difficult question we have tried to answer . . .

The experience of both the northern high-performing Asian economies. . . and the Southeast Asian newly industrializing economies . .. suggests that economies that are in the process of trade liberalization would benefit from providing specific incentives to manufactured exports. Modest subsidies to exports could be linked, for example, to the

11. John W. Mellor, The Economics of Agricultural Development, Cornell University Press (paperback edition), Ithaca, New York, 1966, p. 5.

13. Bruce F. Johnston and John W. Mellor, 'The Role of Agriculture in Economic Development', American Economic Review, 51, 1961, pp. 566-593.

bias against exports in the domestic economy and bound by strict time limits. . . .14

A lesson drawn from the East Asian experience is that export growth is a key to economic development and, in these carefully circumscribed cases, the dynamic benefits from export subsidies have offset the static welfare losses, but that other types of interventions by governments did not succeed in compensating for those losses. These conclusions should be clearly distinguished from the prescriptions of Furtado, who favored strong protection for import-substitution industries and State ownership of heavy industry.

This qualified conclusion in favor of export subsidies, and the consensus that protection of import substitution industries does not work, were both reached primarily on empirical grounds, through review of experience. In addition to the rapid rise of the East Asian economies on the back of a vigorous expansion of exports, another experience that provoked this re-thinking was the decades-long stagnation of the Argentine economy under a policy regime that favored industrial import substitution, and a shorter experience of the same kind in Brazil.

It is now accepted as obvious that industries shielded from international competition have little incentive to improve their efficiency, and hence their productivity growth is likely to be very low, whereas exporting industries, by definition, must maintain competitiveness in world markets in order to survive. Accordingly, a related policy prescription would be that subsidies for export promotion should not be too large or long-lasting, or otherwise exporting industries will come to depend on continuing largesse from the national treasury instead of on improving their own economic efficiency. In fact, in East Asia, 'reliance shifted from export subsidies and tax credits to use of the exchange rate itself to provide export incentives'.15 However, independently of the mode of encouraging exports, the potentials of a dynamic agro-export sector have not played an important role to date in thinking about development paradigms.

The East Asian experience also puts a different light on the supporting role of agriculture in development:

As in other economies, agricultural sectors in the high-performing Asian economies were a source of capital and labor for the manufacturing sector. But in East Asia these resources were generally pulled into manufacturing by rising wages and returns, rather than squeezed out of agriculture by high taxes and stagnant or declining relative incomes. As a result, urban-rural income differentials were smaller in the high-performing Asian economies than in most other developing economies.16

In short, in East Asian economies, policy did not attempt to force the transfer of resources out of agriculture, but rather such transfers as occurred were a natural part of the development process, a process in which agriculture played an important role even though those economies are best known now for their success in industrializing. These experiences conformed to what Vernon Ruttan has called the 'urban-industrial impact model' of agricultural development.17

The conception of agriculture as a handmaiden to the development of the rest of the economy, as a store of labor and capital to be exploited, is increasingly being supplanted by the view that agricultural development should be pursued in its own right, that at times it can be a leading sector in the economy, especially in periods of economic adjustment. The World Bank's World Development Report, 1990, highlighted a number of cases

14. The World Bank, The East Asian Miracle: Economic Growth and Public Policy, published for the World Bank by Oxford University Press, New York, 1993, pp. 354 and 360.

16. The World Bank, 1993, p. 352 [emphasis added].

17. Vernon W. Ruttan, 'Models of Agricultural Development', in Carl K. Eicher and John M. Staatz (Eds), International Agricultural Development, 3rd Edn, The Johns Hopkins University Press, Baltimore, MD, USA, 1998, pp. 155-162.

of adjustment programs in which agriculture responded quicker than other sectors to the new policy regime and grew faster than other sectors for a period of four to five years, leading the economies out of recession. In Chile and Brazil, agriculture grew faster than manufacturing through most of the 1990s. In Chile, agriculture was the main source of new scientific, technical, professional, managerial and administrative jobs during that decade.18

When agro-processing industries, agricultural input sectors and marketing activities are taken into account, agriculture's contribution to total GDP typically lies in the 35 to 45 % range for low-to middle-income developing countries, much greater than the share of primary agricultural output alone would indicate, and almost always much greater than that of manufacturing alone. The bulk of poverty is often found in rural areas and therefore for poverty alleviation purposes, as well as to avoid a swelling of urban shanty towns, agricultural development can claim a place in national priorities.

One of the most important lessons to emerge from the re-thinking of agriculture's role in economic development is that, although agriculture historically has generated surpluses that permit the flourishing of the rest of the economy, this relation does not imply that policy should tax agriculture more heavily, or try to reduce its prices relative to other prices in the economy, in order to extract even greater surpluses from it. However, until the mid- or late 1980s it was common to repress agricultural prices through a variety of policy measures, and the practice continues even today in many countries. Research on this topic found that:

Discrimination against agriculture was significantly greater than had been earlier realized, and was the consequence not only of policies which were oriented toward agriculture, but also was the outcome of overall trade, payments, and macroeconomic policies. A lesson that is valid for all sectoral policies, and not only those pertaining to agriculture, is that the overall thrust of macro economic policy significantly affects the incentives and responses of each segment of economic activity.. . .19

Such policies are self-defeating, in that they reduce agricultural growth and its surpluses and create a greater poverty problem for society. A reduction in agricultural growth means a reduction in overall economic growth. A comparative international study by Anne Krueger, Maurice Schiff, Alberto Valdes and others showed that there is a strongly negative relationship between a policy of taxing agriculture (through both explicit and implicit means) and an economy's overall growth rate.20

One of the earliest quantitative, country-specific analyses to investigate this relationship was carried out for the case of Argentina, and it came to similar conclusions. As a point of departure, the study reported that the combination of a low real exchange rate and high industrial protection constituted a substantial implicit tax on agriculture:

The result of the implicit tax was to extract, on average for the period 1940-73, 50 percent of agricultural output.. . .21

18. Roger D. Norton, 'Critical Issues Facing Agriculture on the Eve of the Twenty-first Century', in IICA, Towards the Formation of an Inter-American Strategy for Agriculture, San José, Costa Rica, 2000, p. 260.

20. See Anne O. Krueger, Maurice Schiff and Alberto Valdés, 'Agricultural Incentives in Developing Countries: Measuring the Effect of Sectoral and Economy-Wide Policies', The World Bank Economic Review, 2(3), September 1988. The negative relationship between agricultural taxation and economic growth is summarized in Maurice Schiff and Alberto Valdés, The Plundering of Agriculture in Developing Countries, The World Bank, Washington, DC, USA, 1992, pp. 10-11.

21. Domingo Cavallo and Yair Mundlak, Agriculture and Economic Growth in an Open Economy: The Case of Argentina, Research Report No. 36, International Food Policy Research Institute, Washington, DC, USA, December 1982, p. 14.

Then the study used an econometric model to construct an alternative scenario of how the economy would have evolved under different policies that included a devaluation of the exchange rate as well as trade liberalization. The new scenario was associated with very substantial increases, of 30 to 40%, in both agricultural and non-agricultural output, as compared to the actual course of the economy. Food prices also increased more rapidly than urban wages under the new scenario, and so one of the conclusions of the study was that a combination of urban food subsidies and a higher real exchange rate should be explored. The policy actually followed of taxing agriculture through trade and exchange rate policies gave highly negative results for all sectors of the economy.

There now is growing agreement that agricultural growth is a key to expansion of an entire economy. In support of this consensus, Mellor has written that:

Typically high growth rates are achieved when agriculture grows rapidly. That is because the resources used for agricultural growth are only marginally competitive with other sectors and so fast agricultural growth tends to be additive to growth in other sectors, as well as being a stimulant of growth in the labor surplus non-tradable sector. . . . Block and Timmer's model of the Kenyan economy22 shows the multipliers from agricultural growth to be three times as large as those for non-agricultural growth.

The explosion in trade and global income mean that agriculture can grow at 4 to 6 percent rate (50 percent higher than what was conceivable three decades ago) even while domestic incomes are too low to make large markets for high value commodities.23

Other reasons for the strong effect of agricultural growth on growth in the entire economy arise from the structure of income and consumption in rural areas: (1) since rural populations are on average poorer than urban groups, their propensity to spend additional income rather than save it is higher than in urban areas, and (2) the composition of their spending is proportionately more weighted toward domestic goods rather than imported goods, as compared to the behavior of urban consumers. These fundamental facts underlie the high income multiplier effects that have been detected in many countries for increases in agricultural and rural incomes.

Part of the beneficial stimulus of agricultural growth takes the form of creating markets for non-agricultural rural goods and services, diversifying the economic base of rural areas. As economies grow, non-agricultural economic activities acquire increasing importance in rural areas. Their development, however, depends in part on agricultural growth. The two are complements, not substitutes, for rural development.

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