By Harald Finger and Nujin Suphaphiphat

January 29, 2026

Strengthening innovation could help boost productivity growth by 40 percent, equal to adding the output of the country's fourth-largest state economy

India's productivity growth over the past two decades has been impressive, reflecting rapid expansion in high-value services, gradual efficiency-enhancing reforms, and scale advantages from a large domestic market. That said, additional gains would support the country's ambitions of becoming an advanced economy.

Better supporting innovation, including by removing business barriers, can boost the productivity growth rate by nearly 40 percent, as we show in our 2025 Article IV report. That significant productivity dividend would be like adding the output of the state of Karnataka, the fourth-largest state by output, to India's economy each decade.

India's productivity performance, measured by output per additional worker, has been uneven. Services have delivered strong productivity gains, benefiting from advances in adoption of digital technology and their integration into global value chains. Manufacturing, however, has seen only small productivity growth, while agriculture-still employing over 40 percent of the workforce-remains far less productive than other sectors. In fact, an additional worker in services produces more than four times the output of a worker in agriculture with the same education level, underscoring the large potential gains from shifting activity to other sectors of the economy.

India's unusually large share of very small firms is one reason manufacturing productivity has fallen behind. Nearly three quarters of factories employ fewer than five paid workers-almost double the US share. Even more striking, the smallest enterprises produce less than 20 percent of the output per worker of large counterparts, compared with nearly 45 percent in the United States.

These challenges reduce India's aggregate productivity. Many of these enterprises remain small for decades due to complex compliance requirements, rigid labor regulations, and product market rules that discourage growth. Easing these constraints would help businesses expand and, in turn, dramatically lift productivity. India's welcome announcement to implement its new labor codes may set the stage for further reforms along this route.

Subdued dynamism

Another factor underlying India's subdued manufacturing productivity is that business dynamism remains low. The frequency of new business creation and when firms close or exit a market is far lower than in economies such as Korea, Chile, or the United States. Subdued dynamism discourages competition and slows the reallocation of resources toward more productive entities.

Further, a sizable share are zombie firms, which don't generate enough earnings to cover their borrowing costs yet are continuing to absorb capital and labor. Our analysis shows that firm entry and exit have only a small effect on productivity in India, highlighting the need for a more dynamic business environment in which unproductive firms can wind down while those that are newer and more innovative can grow and thrive.

Innovation, meanwhile, has remained constrained. India invests less in research and development than the average for emerging market economies in the Group of Twenty, and few firms engage in it, with limited adoption of foreign technology. Larger firms tend to innovate more, while smaller ones have more barriers to scaling up and improving. Strengthening innovation could deliver substantial productivity gains, our analysis suggests. Specifically, lifting India's innovation metrics, including business sophistication and creative outputs, to the 90th percentile of emerging markets could raise productivity growth by almost 0.6 percentage point, or nearly 40 percent relative to India's long-term average.

Role of AI

Artificial intelligence could reinforce these gains. Nearly 60 percent of Indian firms already use some form of AI-well above global averages. AI can make businesses more efficient, speed up technology diffusion, and strengthen innovation. But adoption remains uneven: employers cite skill shortages, inadequate tools, and integration challenges. Ensuring that AI enhances productivity without widening disparities requires further investment in India's already strong digital infrastructure, training workers, and protecting those who may lose jobs.

IMF staff simulations show that AI-driven productivity gains-scaled by AI preparedness and exposure-could raise total factor productivity in emerging Asia (including India) by roughly 0.3 to 3 percentage points over a decade-depending on sectors and scenarios.

India has already laid important foundations for productivity-enhancing reforms and can build on a world-class digital public infrastructure. Unlocking the next wave of growth requires a coordinated agenda: easing regulatory burdens so firms can grow, boosting innovation and university-industry collaboration to promote innovation, strengthening business dynamism, and enabling labor to move to higher-productivity sectors.

With these reforms, India can convert its structural strengths into sustained productivity gains, supporting its endeavors to become an advanced economy.

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Harald Finger is the IMF mission chief for India. Nujin Suphaphiphat is a senior economist in the Asia and Pacific Department.