Islamic Republic of Iran: Selected Issues

This Selected Issues paper discusses some options to strengthen Iran's fiscal framework, and highlights the need for a medium-term framework. Fiscal policy design in Iran faces numerous challenges. Some are current, such as managing volatile oil revenue while addressing development needs. Other challenges are related to demographic pressures from new entrants to the labor market, as the country needs to prepare from aging pressures in the decades to come. With medium-term planning, macroeconomic stability, and adequate spending, fiscal policy could play a critical role in fostering growth. Ultimately, addressing these issues would help Iran achieve its objective of becoming one of the fastest-growing emerging economies.

Abstract

This Selected Issues paper discusses some options to strengthen Iran's fiscal framework, and highlights the need for a medium-term framework. Fiscal policy design in Iran faces numerous challenges. Some are current, such as managing volatile oil revenue while addressing development needs. Other challenges are related to demographic pressures from new entrants to the labor market, as the country needs to prepare from aging pressures in the decades to come. With medium-term planning, macroeconomic stability, and adequate spending, fiscal policy could play a critical role in fostering growth. Ultimately, addressing these issues would help Iran achieve its objective of becoming one of the fastest-growing emerging economies.

The Productivity Challenge in Iran1

1. Stimulating productivity growth is one of Iran’s main economic challenges over the medium term. In their quest to create employment opportunities for everyone and raise income and standards of living, the Iranian authorities have emphasized the need to unlock Iran’s growth potential. This endeavor can only succeed if productivity growth accelerates, as Iran’s catch-up process to productivity levels in advanced economies remains incomplete. The bulk of the existing productivity shortfall is linked to Iran’s relatively low levels of total factor productivity (TFP), echoing the results of earlier cross-country studies (Caselli, 2004; and Hall and Jones, 1999). Physical and human capital levels, in contrast, are closer to international benchmarks. The TFP gap arises in part because frictions in labor, capital, and product markets prevent resources from flowing to where they are most productive. Policy priorities should aim at: (i) invigorating the flexibility and dynamism of the labor market; (ii) pressing ahead with banking sector reform to improve the efficiency financial intermediation; and (iii) strengthening the price signal in product markets. In addition, attracting modern technology from trading partners and specific measures in services and the agriculture sector can play an important role in boosting productivity and income.

A. The Historical Record: Labor Productivity from 1990

2. Labor productivity in Iran has improved considerably, although the gap to the international technological frontier is still yawning. To uncover the long-term structural trends of productivity in Iran, this paper considers data up to 2011, the last year before the tightening of international sanctions. The productivity of Iran’s labor force, measured at purchasing-power parity exchange rates, has risen from less than 20 percent of the U.S. level in 1990 to close to 40 percent in 2011. This performance is better than those of many of developing and emerging market economies. However, two factors suggest that Iran’s productivity growth could have been even higher. For one, other resource-rich countries in the region have realized faster productivity growth than Iran, especially during the upswing of the global oil price cycle in the first half of the past decade. And at 40 percent, the gap to the U.S. productivity level remains sizeable, indicating a large scope for technological catch-up to the global efficiency frontier.

A02ufig01

Real GDP per Worker (PPP)

(percent relative to the U.S.)

Citation: IMF Staff Country Reports 2015, 350; 10.5089/9781513511733.002.A002

Source: Penn World Tables and IMF staff calculations.

3. Sources of productivity gains have fluctuated over time. Jorgensen and Vu’s (2010) growth accounting framework decomposes labor productivity in Iran into contributions from physical capital, human capital, and total factor productivity (TFP).2 This analysis reveals that only human capital has added to labor productivity growth in every year since 1990. But because of Iran’s relatively high level of educational achievement, the marginal impact of human capital has been small. The contribution from physical capital accumulation was particularly important from 2005, coinciding with a period of historically high global oil prices. TFP, on the other hand, significantly boosted labor productivity in the reconstruction phase following the end of the Iran-Iraq war in 1988. Afterwards, its cumulative contribution to labor productivity was about zero, fluctuating from mostly negative in the 1990s to positive in the following decade.

4. The productivity shortfall is mostly related to Iran’s relatively low level of TFP. TFP in Iran, measured at purchasing power parity, was about half of the level found in the U.S. in 2011. The other two determinants of labor productivity, physical and human capital per worker, were at 100 and 74 percent already at or closer to U.S. levels. Elevated levels of capital per worker imply that accumulating more capital will increasingly be subject to diminishing marginal returns, leading to a smaller impact on labor productivity. Diminishing marginal returns will be most pressing for physical capital. By virtue of being an oil-rich country, Iran’s growth model has relied on subsidizing energy. Firms therefore have had incentives to invest in production technologies that use energy, and by consequence capital, intensively. But capital-intensive production technologies have not translated into high labor productivity in Iran, indicating a less efficient use of capital. To make improvements in labor productivity sustainable, they will be based on faster TFP growth.

A02ufig03

Factor Inputs in Iran and Other Emerging Market Economies

(2011; in percent relative to the U.S. level)

Citation: IMF Staff Country Reports 2015, 350; 10.5089/9781513511733.002.A002

B. Sectoral Productivity Trends and Total Factor Productivity

5. Efficiently channeling labor and capital to more productive sectors can lift TFP. Economy-wide TFP growth has many determinants, chief among which is the distribution of labor and capital across industry sectors (Fernald, 1999; and McMillan et al., 2014). That is, TFP growth depends positively on how smoothly labor and capital migrate from less to more productive industry sectors. To measure the contribution of labor movements to productivity growth, McMillan et al., (2014) compute the following the decomposition:

ΔYt=αi,tkΔyi,t+yi,tΔαi,t

where Yt is non-oil labor productivity, yi,t the labor productivity of sector i, and αi,t the share in total employment of sector i. This decomposition emphasizes that economy-wide labor productivity increases because of two reasons: (i) productivity gains in individual sectors (the first sum on the right-hand side); and (ii) employment gains in sectors with relatively high productivity (the second sum). Following McMillan et al., (2014), this paper refers to the “sector-specific” and “structural change” contribution to productivity growth, respectively.

6. Iran’s economy is characterized by a wide dispersion of labor productivity across sectors. Labor productivity in the oil sector was on average 160 times higher than in agriculture, the sector with the lowest labor productivity, in the period 1990-2011. Such productivity differentials are common for “enclave” industry sectors driven by natural resources. As the oil sector is limited in the amount of labor it can absorb, this paper focuses on the non-oil economy. But even in the non-oil economy, significant sectoral productivity differentials continue to exist. Mining and telecommunications had labor productivity levels that were 18 and 14 times higher than in agriculture in 2011. In addition, the dispersion of productivity levels across sectors has actually increased over time—contrary to the experience of rapidly growing emerging market economies, where sectoral productivity levels converge over time. Without frictions, convergence comes about because of diminishing marginal productivities. Labor and capital move from less to more productive sectors, raising average productivity in the unproductive sectors and lowering it in the more productive sectors. The weaker the cross-sector movement of labor and capital, the weaker will be tendency for sectoral productivities to converge. Following this argument, frictions in labor, capital, as well as product markets appear to impede resources from flowing efficiently from unproductive to more productive sectors in Iran.

7. “Structural change” has played only a small role in supporting labor productivity and TFP, consistent with the finding of large productivity differentials across sectors. Over the period 1990-2011, structural change accounted for 15 percent of the total increase in labor productivity. Considering that labor productivity increased by a cumulative 110 percent, about 17 percentage points (0.15 x 110) were due to structural change. Compared to the international experience in McMillan et al., (2014), this performance is mixed. On a positive note, Iran benefited from structural change, as its contribution to total labor productivity was positive (though small). Africa (1990-99) and Latin America (2000-05) were less fortunate as these regions experienced labor movements to less productive sectors over the indicated time period. Less encouragingly, structural change in Iran was meager compared to regions with remarkable growth spurts. In Africa (2000-05) and Latin America (1950-75), labor reallocations across sectors accounted for half of the total gains in labor productivity over the relevant time period.

A02ufig05

Decomposition of Nonoil Labor Productivity Change

(GVA per worker, 1990-2011)

Citation: IMF Staff Country Reports 2015, 350; 10.5089/9781513511733.002.A002

Sources: Iranian authorities and Fund staff calculations.

8. Iran’s more productive industry sectors exhibited only a weak tendency to absorb additional labor. A scatter plot of sectoral labor productivity in 2011 and the corresponding change in employment since 1990 shows no significant relationship. The t-statistic is insignificant at 0.2. Mining, Iran’s most productive industry in the non-oil economy, absorbed no additional labor, which is expected given the sector’s natural capital intensity. The second most productive sector, communications, increased its labor share from 0 to about 1 percent of the non-oil labor force, particularly in the period from 2005 when private mobile phone operators started in the Iranian market. The communications sector is then responsible for the bulk of the positive structural change identified above. The decline in agricultural employment also contributed positively to structural change by freeing up labor in the economy’s least productive sector. However, as the importance of agriculture has shrunk, labor migrated to sectors such as construction and transportation, where productivity was also relatively weak. Previous research highlighted the importance of reducing the employment share of agriculture as a means to boost aggregate productivity (Restuccia et al., 2008). However, the experience of the Iranian economy nuances this result: the labor released in agriculture has to be reallocated to sectors that are more productive and, crucially, remain so over time. Otherwise, aggregate productivity may not gain much.

A02ufig06

Correlation: Sectoral Productivity and Change in Employment

(1990-2011)

Citation: IMF Staff Country Reports 2015, 350; 10.5089/9781513511733.002.A002

Sources: Iranian authorities and Fund staff calculations.

9. Capital also failed to flow to the more productive sectors. Similar to the relationship between employment and productivity, changes in capital bear little relationship to sectoral productivity. The service sector saw the largest decline in capital per worker despite having an above-median level of labor productivity. The transportation sector recorded the largest increase, notwithstanding its relatively weak productivity performance. And the case of the communications sector is particularly telling. Communications is the industry sector with the largest gains in labor productivity over the period 1990-2011. Yet physical capital per worker in the sector actually declined.

C. Towards Policies that Stimulate Labor Productivity

10. Increasing labor productivity in a sustainable manner will require a multi-pronged approach. A range of policies are required to boost both the “structural change” and “sector-specific” components of aggregate labor productivity at the same time; no single policy measure will be sufficient. Policies facilitating a reallocation of labor and capital towards more productive sectors, positive “structural change”, include: (i) invigorating the flexibility and dynamism of the labor market; (ii) pressing ahead with banking sector reform to improve the efficiency of financial intermediation; and (iii) strengthening the price signal in product markets. “Sector-specific” productivity levels, on the other hand, will benefit primarily from: (i) greater economic integration; and (ii) targeted growth policies, particularly for the agriculture and services sectors given their economic importance. Sound macroeconomic policies and continued progress in education, governance and institutions—the “fundamentals” of growth (Rodrik, 2013)—will have to accompany the productivity-specific measures to unleash their full effectiveness. Specifically:

  • Spurring labor market flexibility and dynamism. Iran’s labor market ranks as one of the most rigid worldwide in a yearly index compiled by the Fraser Institute. In particular, complex hiring and dismissal regulations and centralized wage setting procedures beleaguer Iran’s labor market. According to Lagos (2006), policies that distort employers’ decisions about creating new and removing superfluous jobs can have significant detrimental effects on productivity. In the same vein, McMillan et al., (2014) contend that expanding companies will tilt their investments towards capital accumulation and away from new workers if rigid labor market regulation imposes high costs of hiring and firing workers. Iran’s growth strategy of subsidizing energy, which favors the accumulation of physical capital over hiring new labor, compounds this problem. When investment is structurally biased against labor, it reduces the scope for labor reallocations from less to more productive industry sectors. The policy priority should therefore be to ease the rigidity of contracts and increase flexibility in wage determination, which will make labor more attractive.

  • Enhancing the efficiency of financial intermediation. Although Iran’s credit market with a private-sector credit to GDP ratio of around 60 percent (end 2014/15) is relatively deep, it lags in efficiency. Nonmarket factors such as government-mandated credit policies, administered lending and deposit rates, and related-party lending can trump profitability considerations in banks’ lending decisions. The weak profitability and asset quality of Iranian banks are symptomatic of these frictions in the credit market. As a result, capital does not always reach the most productive sectors, and within each sector, the most productive companies. The resulting misallocation in capital can lead to large productivity losses (Banerjee and Duflo, 2005; and Hsieh and Klenow, 2009). Improving the allocation of capital through banking sector reform is therefore a promising avenue towards boosting labor productivity. Specifically, policy should strive to gradually dismantle government-mandated credit policies, empower supervision to enforce prudential limits on related-party exposures, and strengthen governance to ensure that bank management heeds to commercial incentives.

  • Strengthening the price signal in product markets. In Iran, the government mandates the prices for many outputs of the agriculture, manufacturing, and construction sectors. Yet these administered prices do not always reflect demand and supply forces, thwarting incentives for and profitability of new investment. Giving a greater weight to market forces in the determination of the affected output prices will tend to increase investment in high-productivity sectors and companies. Investment rates biased towards high productivity will help attract labor and capital from other parts of the economy, boosting the potential in Iran for growth-enhancing “structural change.”

A02ufig08

Labor Market Flexibility Index

(2013; 10=flexible, 1 = rigid)

Citation: IMF Staff Country Reports 2015, 350; 10.5089/9781513511733.002.A002

Source: Fraser Institute.

11. In addition to fostering “structural change,” aggregate labor productivity will also thrive on the back of measures that propel “sector-specific” productivity levels. In particular:

  • Integrating more closely with regional and international markets. Greater economic integration facilitates the transfer and adoption of new technologies and spurs competition. Grossman and Helpman (1991) and Aghion and Howitt (1992) highlight frictions in technological diffusions as a determinant of TFP differences across countries. The data seem to corroborate the notion that Iran’s industry sectors do not operate with frontier technology. Iran’s non-oil economy substituted away from domestically produced towards imported inputs in the ten years to 2011, suggesting a loss of competitiveness of Iranian industry in the eyes of Iranian producers. Similarly, labor productivity in Iran’s agriculture, construction, and service sector are significantly below levels seen in advanced economies, despite relatively high levels of human capital (suggesting that skill mismatches à la Acemoglu and Zilibotti, 2001, are not the main reason for lagging technological adoption). This shortfall highlights the scope for lifting sectoral productivity through foreign direct investment and the ensuing transfer of modern technologies.

  • Targeting growth policies to agriculture and services sectors. More than half of Iran’s labor force works in agriculture and services. Productivity improvements in these two sectors are therefore crucial to raise economy-wide productivity and growth. The service sector in Iran is ighly regulated and has high barriers of entry, stifling competition. In fact, in a sample of 51 countries in the World Bank’s Services Trade Restriction Database, the Iranian service sector ranks as the most restricted for international trade. Removing regulatory barriers on foreign ownership and operations in the Iranian market with a view to intensify competition seems promising to increase productivity. Competitive pressures are likely to speed up the adoption of IT to reorganize business operations in service sectors such as retailing, consulting, and science. Business reorganizations with the help of IT were significant factors in accelerating TFP growth in the U.S. in the mid-1990s (Fernald and Wang, 2015). As for agriculture, crosscountry evidence points to the importance of land and tenancy reform in boosting productivity in agriculture. Iran has already taken steps to develop more modern agricultural practices such as horticulture and floriculture. These activities have higher value-added content than traditional fields such as rice paddy farming.

A02ufig10

Services Trade Restrictiveness and Service Sector Productivity

(measured in PPP; 2008)

Citation: IMF Staff Country Reports 2015, 350; 10.5089/9781513511733.002.A002

Sources: UN National Accounts database, ILO, World Bank, and IMF staff calculations.

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1

Prepared by Robert Blotevogel.

2

For a development accounting exercise focusing on the level of Iran’s GDP per capita and its cross-country comparability, see the 2014 Article IV Consultation (Country Report 14/93)

Islamic Republic of Iran: Selected Issues
Author: International Monetary Fund. Middle East and Central Asia Dept.