The Impact of Trade Liberalization on Informality: Evidence from Egypt and Kenya

In 2015 the Common Market for Eastern and Southern Africa launched the Tripartite Free Trade Area, a continental trade agreement meant to boost intra-African trade. In addition to more extensive trade liberalization, these agreements are expected to significantly impact labor market dynamics and, according to most observers, boost employment opportunities. Most studies to date examining labor market outcomes in member countries focus only on the changes in formal employment opportunities. This is an important shortcoming because in many African countries, informal employment represents 50% or more of total employment. This thesis examines the impact of these deregulatory trade policies in two of the member countries, Egypt and Kenya, which have implemented several waves of trade reforms. The first part of the thesis offers a modified 3x3 general equilibrium model to assess the impact of tariff reduction on informal production and wages. The modifications are based on Razmi\u27s (2007) export processing zone model, reflect key African labor market institutions, and incorporate assumptions of capital immobility and backward vertical linkages from Marjit (2003) and Marjit & Maiti (2005). The second part empirically evaluates the effect of trade reforms on informal employment, real wages, and formal-informal wage differentials, using data from labor force surveys provided by the Kenyan National Bureau of Statistics and Egypt’s Economic Research Forum, and tariff data from the World Trade Organization. I use a two-step econometrics model developed by Goldberg & Pavnick (2003). The first step employs a probit model to capture the variation in informal employment explained by industry-affiliation and produces normalized industry informality differentials using the Haisken-DeNew and Schmidt (1997) two-step restricted least-squares procedure. The second step employs WLS to regress the industry informality differentials against a set of industry-related trade variables. To evaluate the effect on wages, the two-step approach is repeated in order to estimate industry wage differentials