Returns to Capital and Informality

In this paper we analyze the pattern of returns to capital in formal and informal manufacturing sector in Ethiopia using a rich panel dataset of formal sector manufacturing firms for the period 1996-2006 and two rounds of repeated cross-sectional data from the urban informal sector firms. Returns to capital in the informal sector are higher than that of the formal sector potentially explaining the growing informal sector in Ethiopia. Median return to capital in the formal sector is between 17-21% while that of the informal sector ranges from 51-122 percent. However investment in the informal sector is limited by the evidence that returns to capital is declining as the amount of time owner spent in the enterprise declines. This restricts the possibility of formal and informal firms to establish many identical firms in the informal sector to take advantage of the higher returns to capital in the sector. Unlike the prediction of poverty trap hypothesis, we find that returns to capital are decreasing with capital stock creating the opportunity for small firms to grow by re-investing their profit. Parametric and semi-parametric regression techniques are used to study the magnitude and pattern of returns to capital. Using dynamic panel re-investment models in the formal sector, we found that small firms with higher returns to capital make significantly higher re-investment though the coefficient estimates are low.