The Role of Institutions in Determining Formal-Informal Earnings Differentials: Panel Data Evidence from South Africa

In South Africa poverty is a function of lack of formal sector employment, where wages can exceed those in informal employment by a factor of twelve. Cross section data shows that observable human capital, while important, fails to explain a very substantial part of this difference. In this paper the KwaZulu-Natal Income Dynamics Study (KIDS), a relatively long panel, is used to investigate two dimensions of formality and informality public relative to private sector employment, both wage and self-employment, and unionisation as sources of these differentials. We find that once unobserved heterogeneity is allowed for there is still a highly significant, 60 per cent, differential for being in the public rather than the private sector while the union premium in the private sector is much smaller, about 15 per cent, and not significantly different from zero. There is no differential between private regular wage employment and self-employment. These results are robust to corrections for attrition. They also suggest that policy needs to focus, not on the harm unions do to employment creation through raising wages, but the limits high public sector wages impose on the ability of the private sector to create more, but lower paying, jobs.