The Returns to formality and Informality in Urban Africa

This paper addresses the question as to why we observe such large differentials in earnings in urban African labour markets after controlling for observable human capital. We first use a three year panel across Ghana and Tanzania and find common patterns for both countries assuming that movement between occupations is exogenous. Unobserved individual market ability is by far the most important factor explaining the variance of earnings. Sector differences do matter even with controls for ability and the sectoral gap between private wage employment and civil servants is about 50 per cent, once we control for unobserved time-invariant factors. Wage earners earn the same as the self-employed in both Ghana and Tanzania. An additional important aspect of formality is enterprise size. At most half of the OLS effect of size on earnings can be explained by unobservable ability. Workers in largest firms are the high earners with wage rates which exceed those of civil servants. We then use an extension of the Ghana panel to five years to assess the extent of possible biases from the assumption of exogenous movement. We find evidence that this is important and that OLS may be understating the extent of both the size effect and the private sector wage (negative) premium. The implications of our results for understanding the nature of formal and informal employment in Africa are discussed.