Effect of the Size of the Informal Sector on Economic Growth, Total Factor Productivity and Poverty Alleviation in Kenya
Opondo, Mary Awuor
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The Kenyan economy is predominantly informal. The informal sector employed 132,100 workers in 1974; and 13,442,200 workers in 2016, which translate to 19 percent and 84 percent of the total work force in the respective time periods. The government has from 1986 put in place policy measures to develop the sector for employment creation, economic growth, and poverty alleviation. Among the country‟s Big Four Agenda as contained in the Medium Term Plan (2018-2022), is the development of the manufacturing sector for economic growth and improved welfare. The manufacturing sector in the country is largely informal with 80 percent of firms and 84.3 percent of the total workforce being informal. The development of the sector is therefore central in the achievement of the country‟s macroeconomic targets of 10 percent annual economic growth rate and a reduction in poverty rates to 28 percent of the total population by the year 2030. However, theoretical and empirical literature point at a sector that has low productivity with some studies attributing poor economic performance to the existence of a large informal sector. This study aimed at establishing the effect of the size of the informal sector on economic performance in Kenya. The study objectives were; to analyze the contribution of the informal sector to output growth in Kenya, to determine the effect of the informal sector on total factor productivity in Kenya; and to examine the effect of the informal sector on poverty alleviation in Kenya. The study used secondary time series data for the period 1974 to 2016 and employed Ordinary Least Squares in analysis. Data was sourced from the country economic surveys and statistical abstracts, the Central Bank of Kenya website, the World Development Indicators and the Global Financial Development database. A growth accounting exercise was conducted using the standard Cobb-Douglas production function to address the first objective. The study used the residual from the growth accounting exercise, commonly referred to as total factor productivity as the dependent variable to address the second objective based on endogenous growth models with the growth in the average annual wage in the informal sector as an indicator of the size of the sector following efficiency-wage theories. The third objective was based on the Marxist and Liberal theories of poverty. The poverty headcount index was used as the dependent variable with the depth of informality as an indicator of the size of the informal sector. From the study findings, the informal sector is the lowest contributor to output growth in the country; the sector has a negative and statistically significant effect on total factor productivity; and significantly increases poverty in the country. Based on the findings, and given the size of the informal sector, the study concludes that there is a need to target increased productivity in the sector for increased output growth, increased total factor productivity and poverty alleviation in the country.