Economy Diversification Index

[Amice Golden]

Economicdiversification drives equitable growth and global resilience. It involves active private sector involvement, government policy reforms, and investments to move away from reliance on limited products. The Global Economic Diversification Index (EDI) measures this evolution since 2000.

The 2024 edition covers 112 countries, showing that digital economy investments enhance trade diversification, benefiting even small economies like Singapore and Ireland. Commodity-dependent nations can improve diversification through digital technology adoption. Geographical size doesn't hinder diversification, as evidenced by high-scoring small nations like Singapore and Ireland.

In the last 100 years, instances of disaster and national crisis have increased 50-fold, with their severity and frequency also rising over time. In a context of urgency, the leaders of today have a duty to foster a culture of resilience and build th

In its 6th Edition, the Government Services Forum, part of the World Governments Summit 2024, brought together senior leaders from the public and private sectors from around the world to engage in a dialogue on the future of government services.

Given the importance of diversifying African economies, it is critical to recognize how various dimensions of diversification can have different implications for the menu of policy options. Closely associated with the process of structural transformation from lower to higher productivity sectors, economic diversification has three evident dimensions. The first relates to the expansion of economic sectors that contribute to employment and production or gross domestic product (GDP) diversification, and the second is associated with international trade or exports diversification. This paper, however, focuses on a third dimension that the economics literature pays scant attention to: fiscal diversification. This fiscal element involves expanding government revenue sources and public expenditure targets and can therefore play a central role in helping to catalyze broader economic transformation through the expansion of activity in specific industries and sectors.

In terms of measurement, two sets of tools are highly relevant and applicable to assessing economic diversification. Among economists, the Theil Index has emerged as the most widely used tool to measure exports diversification. It can also be used to calculate fiscal diversification and has critical technical advantages. However, efforts to leverage these advantages have so far been limited to the measurement of trade diversification. Among development practitioners, the Public Expenditure and Financial Accountability (PEFA) framework is the most widely used tool to assess the strengths and weaknesses of public financial management (PFM) performance, which has implications for fiscal diversification. But to use PEFA in an assessment of fiscal diversification, information on fiscal policy would be needed to help determine whether government revenue collection and spending is sustainable and effective in spurring economic transformation or achieving other policy objectives.

In addition to expanded ways to conceptualize and measure economic diversification, the structural and socioeconomic characteristics of African countries must be reflected in any approach. As extensive literature on economic diversification demonstrates, there are a range of factors, including population size; per capita income; institutional development; and financial, physical, and human capital. Due to sharp internal differences along urban-rural or coastal-inland lines, the challenges of economic diversification can assume a spatial dimension within some African countries. Overall, two factors appear to have an outsized relationship with economic diversification: income levels (in other words, whether low, middle, or high income) and its dependence on nonrenewable natural resources.

Traditionally, economic diversification involves transitioning away from dependence on one or a few commodities such as crude oil, minerals, and agriculture production toward a broader range of sources of production, employment, trade, revenues, and expenditures. Among economists, the process that is most closely associated with this policy objective of economic diversification is structural transformation, which is characterized by rising productivity, sustained growth, and broader development. It is structural transformation that facilitates the diversification of sources of production and employment, international trade, revenues, and expenditures through various dimensions.

The growth in some economic sectors may provide intermediate inputs to the growth of others and thus diversify the sources of employment and output. For instance, several scholars point to how underdeveloped financial markets create frictions that decisively affect output per worker, aggregate and sector-level productivity, and investment ratios. Financial frictions in developing countries have a severe impact on the manufacturing sector. According to Francisco Buera, they result in a 50 percent decline in productivity, higher relative prices of manufactures compared to services, and a 15 percent decline in investment ratios.21 Hence, the informal sector, which is characterized by low wages, skills, and productivity, tends to be prevalent in these countries as the main source of output and employment.

Various aspects of fiscal diversification have been addressed in theoretical, empirical, historical, and policy literature on how public finance relates to policy objectives. Thus, the main conceptual elements of fiscal diversification are not new. What is new, in this analysis, is the fusion of these elements to conceptualize fiscal diversification as both an indicator of structural economic change (production, employment, and trade) and as a mechanism or tool for policymakers to catalyze economic change.

On the expenditure side, government spending can both catalyze and constrain the growth in employment and output of economic sectors. An expansion in the number of government expenditure targets can indicate a shift from subsidies to specific economic sectors, such as primary commodities or heavy industries or basic public services. It can also reflect structural economic changes in production and employment. Through expenditures, governments can free up resources that might otherwise be allocated to suboptimal economic sectors and reallocate them to sectors that provide higher economic and social returns. Government spending and associated policy to help ease credit constraints can help smooth financial frictions that otherwise distort the allocation of capital and entrepreneurial talent across firms, industries, and sectors.42

Some studies suggest that government spending may target certain constituencies as a way to induce tax compliance. For instance, Jeffrey Timmons found that governments that rely relatively heavily on taxes paid by poor people (regressive taxation) will tend to motivate these relatively impoverished taxpayers through social spending on public services; and those governments that rely more heavily on taxing the rich (progressive taxation) will motivate them by providing relatively high levels of protection for property rights.43

In the last two decades, domestic revenue generation has dramatically increased among African countries (see figure 4). Furthermore, as Moore and others note, governments in Africa are collecting taxes more effeciently than other governments in some low-income regions and are making consistent, gradual progress in improving their revenue systems. As a result, they are capturing a higher proportion of national income for public purposes.48 Meanwhile, in sub-Saharan Africa, net official development assistance (ODA) has declined from a peak of 5.1 percent in 2003 to 3 percent in 2017 (see figure 5), though considerable cross-country heterogeneity exists. For instance, development assistance accounts for 20 percent of gross national income in The Gambia, Liberia, Malawi, and Somalia. Furthermore, overall, Africa is more dependent on ODA than any other region; in 2016, it received about 33 percent of total ODA from donors of the Organisation of Economic Co-operation and Development.

These dimensions and measures of economic diversification matter because they determine the menu of policy options for a country. Structural differences, such as natural resources wealth and government effectiveness, have implications for the specific challenges of economic diversification in any country. Many of these structural characteristics are on full display in Africa. According to World Bank data, twenty-three African countries are classified as low-income, thirty are middle-income, and one, Seychelles, is high-income. In terms of natural resource endowments, twenty of the fifty-one African countries that have available data are considered resource-rich (with resource rents accounting for 10 percent or more of GDP) and thirty-one are considered resource-poor (see figure 8). Finally, the quality and effectiveness of governance vary greatly across the continent, with twenty-eight of the fifty-four countries scoring a 50 or more on the Ibrahim Index of African Governance, which has a maximum value of 100, and the remaining twenty-six scoring below 50. These structural differences should be considered when measuring and interpreting the economic diversification outcomes of countries, as they have critical policy implications.

Within other countries, economically productive and diversified areas, or growth poles, are clustered around the national capital, while the hinterlands predominantly engage in subsistence agriculture. This is the case in Ethiopia, Madagascar, and Rwanda. This phenomenon often takes place in countries that are home to special economic zones or export-processing zones, as the special tax-exempt status of such zones can make them more competitive than other areas. Both cross-country analyses and country-level policy recommendations are of limited utility in cases where stark interregional inequalities and corresponding diversification gaps persist. By looking at national-level measures of diversification like the ones presented in this paper, central governments may conclude that a lack of diversification is a problem at the national level when it may in fact be more predominant at a subnational level and necessitate different policy responses.

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