On the anniversary of the bloodless revolution that toppled a long-standing dictatorship in April 1974, Portugal looked back on a generation that had transformed it into a modern European economy. But the jubilee also marked another turning point: the need to create a new path toward growth. To drive the economy forward, the country can no longer rely on integration with the rest of the European Union or on the fact that until now wages in Portugal have been among the lowest in the trade bloc. Indeed, the process of catching up with the wealthier EU economies has lately ground to a halt. It is high time Portugal tackled the underlying cause of the wealth gap: its low labor productivity.

Raising productivity will be increasingly important if Portugal is to compensate for the erosion of the cost benefit it used to enjoy by virtue of low wages. Over the past five years, its traditional industries—such as the manufacture of clothing and footwear—have been hit by tough competition from Asian countries where wages are even lower. At the same time, Portugal must compete for foreign investment with the former Communist states of Eastern Europe. That rivalry is set to intensify this year as many of these countries,¹ which also have the advantage of being closer to the Continent’s main markets, join the European Union.

Narrowing the gap

Portugal’s quest to narrow the gap between itself and wealthier countries such as Germany and France began in earnest when it joined the EU in 1986. Membership brought access to a large free-trade area, a huge inflow of development funds (mainly used to modernize infrastructure), and an initial wave of industrial privatization and liberalization.

The result was an economic boom. Portugal substantially outperformed most other member countries from 1986 to 1991, when its GDP per capita grew by an average of some 6 percent a year. A second integration wave, which began in 1993 with the introduction of the European Single Market, was characterized by macroeconomic discipline to prepare for the rollout of the euro (which Portugal, along with ten other EU members, launched in 1999). Propelled in particular by the ongoing deregulation of banking and telecommunications, Portugal continued to grow alongside its larger neighbors, albeit more slowly.

Since 1999, however, growth has stagnated in Portugal (Exhibit 1), and its economy has suffered one of the worst recessions in Europe. Today the country’s GDP per capita is 54 percent lower than Germany’s—less than the 65 percent gap of 1986, but still a huge discrepancy.²

A new path toward growth

To speed up the economy, Portugal must tackle the underlying cause of the GDP gap: the lower productivity of Portuguese workers. Their output is just 52 percent of the average of workers in Germany, France, Italy, the Netherlands, and Belgium—the top five EU countries, for which comparable data are available. Higher productivity generates an economic surplus, which becomes available to consumers as lower prices, to employees as higher wages, and to shareholders as higher profits. As a result, higher productivity can boost not only demand, investment, and exports but also, by extension, the pace of GDP growth.

To understand the reasons for Portugal’s low productivity, in 2003 McKinsey’s Lisbon office and the McKinsey Global Institute (MGI), in collaboration with the Portuguese Ministry of the Economy and with the participation of advisers from other ministries, studied seven sectors: automotive, food retailing, residential construction, retail banking, road freight, telecommunications, and tourism.³ We found that roughly one-third of the overall productivity gap is caused by structural factors—notably a relatively low per capita income—that cannot be changed by public policies. The average Portuguese bank customer, for example, holds assets and liabilities worth 60 percent less than those of an average customer in the Netherlands. This shortfall reduces the bank’s revenues per customer, though the cost of serving each one is about the same in both countries. In addition, at Portugal’s current stage of economic development, labor is relatively cheap as compared with capital—a fact that discourages the use of productivity-enhancing machinery. Portugal’s relatively small population (10.4 million) makes it harder for large domestic companies to reach optimal size.

If the country can generate strong and sustained economic growth, the importance of these structural limitations on productivity will fade. But to make this happen, Portugal must work to eliminate the nonstructural barriers that hinder productivity (Exhibit 2).

Back to the roots

We have identified three reasons for Portugal’s relatively low productivity: distorted competition, deficiencies in the public sector, and rigid labor markets (Exhibit 3).

Distorted competition

Productivity in the domestic sectors of Portugal’s economy is particularly low. Industries such as construction and food retailing are naturally sheltered from international competition and face distorted domestic competition. The government should make establishing the conditions for competitive markets in these industries a priority.

The most important reason for distorted competition is the informal economy—sometimes called the gray economy—in which companies don’t register with the authorities, pay taxes, or follow regulations. Up to 23 percent of Portugal’s economy operates informally, estimates the International Monetary Fund (see "The hidden dangers of the informal economy," to be published on mckinseyquarterly.com in June 2004).

In the residential-construction industry, for example, informality accounts for more than a quarter of all hours worked—and for more than half of the sector’s non-structural productivity gap. Informality lowers productivity in several ways. The evasion of labor taxes makes labor cheap relative to capital, thus reducing incentives to use productivity-enhancing equipment and to adopt best-practice operations and management processes. Parts and materials tend not to be standardized, since the use of prefabricated materials makes it harder for firms to avoid paying taxes. Above all, the presence of informal firms slows down the growth of more efficient formal ones; indeed, tax evasion makes the profit margins of informal firms three percentage points higher than those of their bigger, more efficient, and law-abiding competitors. This advantage not only allows informal firms to stay afloat when conditions get tough but also encourages them to remain subscale so that they can avoid scrutiny more easily. The result is a highly fragmented industry with few players that can reap advantages of scale; the five largest residential-construction companies hold only 4 percent of the market.

Portugal’s problems with its informal economy are not unique, and they can be solved. Neighboring Spain, which until recently suffered from an equally large gray economy, has successfully put pressure on smaller companies to improve their productivity or be replaced by more efficient operations. The Spanish government tightened auditing standards for tax, social-security, labor, and other legal obligations by integrating its existing databases and automating the cross-referencing and checking of data. Spain then introduced readily enforceable taxation systems—tailored to the needs of each sector—for small and midsize companies, created a bureau to fight tax evasion, and instituted a faster court process to deal with it. In the program’s first three years, tax revenues from small and midsize companies rose by more than 75 percent. A similar system, also tailored to the needs of individual sectors, is now being implemented in Portugal.

Another cause of distorted competition in Portugal is regulation, such as rules that inhibit productive companies from entering into or expanding within certain markets. In food retailing, for example, a 1997 law (now being revised) allows large, productive retail formats, such as supermarkets and hypermarkets, to control no more than 35 percent of the market. Since 2001, operators of large food-retailing outlets have failed to gain approval to open new stores. Portugal thus has a relatively high share of employment in less productive, small-store formats. Other regulations restrict operations: tourist hotels, for instance, are required to stay open throughout the whole year.

Zoning laws, business-licensing requirements, and the red tape involved in obtaining permission to do this or that not only raise the cost of doing business but also distort competition, particularly in construction and tourism, where the plethora of regulations from different public bodies leads to overlaps and a lack of coordination. Procuring a license to build a hotel, say, involves applications to at least five public entities and can take more than five years. What’s more, the opaque and complex nature of the licensing process often limits a developer’s access to attractive sites for large-scale housing. The result is smaller and less productive projects and an unfair advantage for companies—not necessarily the most efficient ones—that have strong local connections and thus can cut through red tape.

Public-sector deficiencies and rigid labor markets

In sectors subject to international competition (such as automotive, textiles, and tourism), the nonstructural productivity gap can be traced in part to certain public-sector deficiencies and to inflexible labor regulations. Indeed, we estimate that these two factors—also cited when investors rate Portugal in surveys of international competitiveness—are responsible for more than 80 percent of the nonstructural productivity gap in the automotive sector.

Portugal’s public sector is a burden on the economy as a whole. The problem isn’t its size, which at 15 percent of total employment is slightly below the EU average, but rather the high wages paid to its employees: a 51 percent premium over the private sector (compared, for instance, with 7 percent in Germany). High wages impose a fiscal burden reflected in corporate-taxation levels that are out of proportion to the benefits companies receive from the state. This problem discourages international operations from investing more in the country.

In the automotive sector, for example, the inadequate technical education available to blue-collar workers obliges companies to spend extra time and money training employees to use the machinery that would raise their productivity. To address these problems, Portugal’s public sector requires broad reform of the kind introduced in the United Kingdom and other European states, which measure performance by results and have privatized many services or opened them up to the private sector.

As for labor regulations, despite a degree of relaxation in December 2003 these continue to hamper the country’s ability to attract new foreign direct investment. In the automotive and tourism sectors, for instance, employers still have difficulty adapting the size of their workforce to the economic cycle or, in the case of tourism, to the intrinsic seasonality of the business. Hotels are required to have a certain number of employees to fulfill each role—cashier, receptionist, housekeeper, bartender—depending on the number of rooms. The law also forbids staff to switch among different functions. Portuguese hotels therefore employ more people than do hotels in other EU countries, and productivity in Portugal’s tourism industry as a whole is 56 percentage points lower than it is in France. Around 29 percentage points of this gap are due to labor regulations.

Stuck in the middle

Distorted competition, deficient public services, and labor laws that prevent domestic companies from building scale and discourage foreign players from investing in Portugal have created a highly fragmented industrial landscape. In the textile sector, for example, 53 percent of companies have fewer than ten employees. Furthermore, by reducing the incentives for firms to innovate, such barriers have led industries to focus on low-value-added products. The automotive-components subsector is a case in point: some 35 percent of Portuguese workers in it make labor-intensive electric cables; in France, no one is so employed.

The lack of scale and skills makes it hard for companies based in Portugal to generate or finance growth. Compared with other EU countries, Portugal still has some way to go in matters such as R&D expenditures, new patents, venture capital investment, and the proportion of start-ups in total employment. These problems are particularly relevant because the country has reached a stage in which it risks getting "stuck in the middle"—with wages that are too high for it to compete against Asia and Eastern Europe in the manufacture of low-value-added products, and with products that don’t offer sufficient value for it to compete against more advanced economies.

By tearing down the barriers to productivity, the government would stimulate domestic and foreign investment. Bigger and more efficient companies would gradually dominate industry, and the economy would rise to a higher level of development. By 2010, we estimate, Portugal could raise its labor productivity to about 70 percent of the level in the most advanced EU countries, from 52 percent now. With these developments would come a significant increase in the welfare of Portugal’s citizens: GDP per capita would rise to 82 percent of the average level in the top five European countries, from 70 percent.

Portugal faces a challenging but by no means impossible task. The dramatic productivity gains already achieved in the retail-banking sector demonstrate the leaps that can be made even in industries with limited global competition. Full deregulation of retail banking in the 1990s—including the removal of credit ceilings and of obstacles to the opening of new banks—unleashed tough competition that led to consolidation. From 1998 to 2001, the sector’s nonstructural productivity gap with Europe’s best levels thus narrowed to 11 percentage points, from 43.

In September 2003, this diagnosis of the challenges facing the country led its government to approve some 20 initiatives to eliminate the barriers to productivity growth. The results of the program, which involves most areas of public administration, will be tracked by a barometer that every month measures the progress of key productivity indicators, such as levels of tax collection in sectors affected by the gray market and the average number of days needed to register a new company.

Unlike many countries at a similar stage of economic development, Portugal is in the enviable position of having already achieved political and macro-economic stability; it is also fully integrated into the European Single Market. If Portugal can remove its barriers to productivity, investment, and growth, the road lies open to a substantial increase in its standard of living.