Decomposing the Labor Productivity Gap Between Formal and Informal Firms in Kenya

Abstract

Formal firms are generally associated with higher productivity than informal firms. This is a concern because low productivity of informal sector firms means low income for those entrepreneurs. Moreover, it has been argued that informality deters investment and productivity growth in the private sector, which is key to creating decent jobs and reducing poverty. Despite these concerns research on productivity differences between formal and informal firms in Kenya is limited. Therefore, this study explored labor productivity gap between formal and formal firms and decomposed the gap into various factors. The study used data of 696 firms extracted from the World Bank 2018 Enterprise survey and Oaxaca-Blinder decomposition analytical framework. Firms that were unregistered firms at start up were found to be 52 per cent less productive than firms that registered at start up. The labor productivity gap is explained by both endowments and structural effects. The significant contributors of labor productivity gap via endowments effects are Indian ownership, external audit, quality certification and closed shareholding while foreign ownership, mobile money, tax rates and medium sized firm are the significant contributors of labor productivity via structural effects. This research adds to literature on firm productivity differences in Kenya. Given that formal firms are more productive than informal firms findings are helpful to private firm and government policy makers and can help tackle low productivity in informal firms while enhancing productivity of formal firms.