Labour Market Failure, Capital Accumulation, Growth and Poverty Dynamics in Partially Formalised Economies: Why Developing Countries’ Growth Patterns are Different

The assumption of perfectly functioning labour markets is ubiquitous in growth theory, yet incompatible with equally ubiquitous poverty in developing countries’ informal sectors. We argue that developing countries and high-income countries differ as in the former, induced by informal sector poverty, the macroeconomic labour market fails with the result of a persisting wage differential between the well-observed formal and the unobserved informal sector. In such setting, formal sector employment growth is driven by formal sector capital accumulation, formal sector capital accumulation is free from diminishing returns and growth is endogenous. These propositions hold as long as informal sector poverty exists. Empirical testing using panel data and cross-sectional data from a stable sample of 73 developing countries provides strong support for these findings.