In most developing countries, the informal economy accounts for a large portion of the national economy and it often has a negative connotation because of inferior working conditions, low-productivity firms, and disrespect for the rule of law. The firms and workers as well as their output and production activities that are unregistered and do not pay taxes account for a significant and growing share of total economic activity. In Indonesia, BPS-Statistics Indonesia (BPS-Statistic Indonesia, 2022) records that the informal sector reaches 59.31% with more informal economy workers in rural areas. It captures three provinces including Papua (84,11%), West Sulawesi (77,25%), and West Nusa Tenggara (75,36%), with the highest percentage. The informal sector – where most MSMEs operate – employs more than 61 percent of Indonesia’s total workforce (The World Bank, 2010). From a government or formal perspective, the large participation in the informal sector becomes an issue that must be resolved because restricts the government’s ability to provide support for public goods and services (tax issue) and hinders economic growth.

In addition, policy-makers assume that their status (as companies and informal workers) would put them at a disadvantage relative to formal firms because they may not be able to legally obtain credit from formal financial sources, access government programs or facilities, or export products. The fact that is not surprising anymore is, even though actors in the informal sector know those losses mentioned by the government, most of them remain in their position. This phenomenon is interesting to examine because it has a lot to do with economic growth, social welfare, human capital, institutional issue, to development in various sectors. Therefore, this paper will analyze why the percentage of informal employment remains high in Indonesia despite many efforts by institutions and state agencies.

The Informal Sector: Exclusion & Exit Theory

Informal employment is a phenomenon in which firms and workers are unregistered with social security administrations, meaning their work activity and income are outside the tax control of the state and of the legal provisions in labor matters – most of them are small firms. Some literature analyzes the reasons firms or workers choose to remain in the informal sector on the one hand and the reasons other companies register their firms (and workers) and pay taxes. Perry et al. (2007) highlight informality through two lenses, exclusion & rational exit. The exclusion theory argues that the informal sector exists because workers could not find jobs in the formal sector, more precisely they are excluded from critical state benefits or modern economic circuits. Those exclusions include segmentation in the labor market, burdensome entry regulations that prohibit small firms shift to formality and growth, and informality as a defensive measure toward excessive tax and regulatory burdens. Therefore, the rational exit theory states that the net benefits of joining the formal sector are negative. Firms and workers choose to engage with formal institutions based on cost-benefit analysis, depending on their assessment of the net benefits associated with formality and the state’s enforcement effort and capability. This view suggests that high informality results from a massive choice to leave formal institutions by firms and individuals. It implies societal demand on the quality of the state’s service provision and enforcement capability.

They also argue that formality increases rapidly with firm size and productivity. So, formality can be seen as an input in the production process that is not really needed by small firms. However, most micro firms remain too small to benefit sufficiently from formality to overcome their various costs (a survey of informal Mexican micro firms). Other reasons are the high costs and time required to register or the high costs of operating as a registered business. In their research, the degree of formality increases as the firm grows larger and their demand for formalization increases, as does the probability of detection by authorities. Firms choosing to register do have better performance or, the firms that started operations being registered exhibit higher levels (on average) of labor productivity than their equivalent unregistered peers (survey in Latin America). However, there is evidence that, in some cases, informality reflects defensive evasion of possibly excessive regulation. In short, firms not only consider the cost and benefit of formality but their environment that does not demonstrate demand for its expected benefits also influences their decision. For the last, even if the government reduced registration costs, it would not lead to formalization. In other cases, such as unskilled workers – with lower formal wages, they may find that paying social protection and expected returns from a formal job do not exceed their consumption or greater flexibility and income they can get as informal workers. Especially when they have social protection alternatives from private or noncontributory programs (Perry et al., 2007). However, informality is a multidimensional phenomenon in which exclusion and exit mechanisms depend on each country based on its institutions, historical background, and legal frameworks.

The analyses highlight the characteristics of informal workers, their motivations, and their preference for the benefits and non-monetary characteristics of jobs such as flexibility, autonomy, stability, and mobility. Most of these informal workers seem to choose their jobs according to their individual needs, particularly their desire for flexibility and autonomy, and their abilities (comparative advantage). Either independent workers (firm owner and self-employment) or informal salaried workers are related to the exclusion and exit model. Most independent workers choose their jobs voluntarily, exit the formal social protection system, and underline the non-monetary of self-employment. In contrast, most informal salaried workers are excluded from more desirable jobs, either as formal workers or self-employed. They also choose not to contribute to social security and health insurance plans (exit) mainly because of low incomes and their employer’s decision not to offer benefits. Based on Perry’s research in Latin America, most of the self-employed do not appear to be excluded from the formal sector but they choose to exit (rationally, cost-benefit) of formality. They considered their minimal human capital, access to other assets, and low aggregate productivity in the economy. Informal employment then becomes a better option than suitable jobs in formal ones.

The dualism of the Informal Sector

Furthermore, Rizki, Suryadarma, & Suryahadi (2020) used dual economic theory in their research on informal workers in Indonesia in the 1996-2014 period. The dual economy theory argues that the informal and formal sectors co-exist, and are fundamentally different. They produce different products, with different labor, capital, and technological inputs that automatically have different productivity levels, and also pay different levels of wages and serve different consumers. This theory assumes that changes in registration costs will have no impact on the size of the informal sector in the dual economy model. Only economic growth could solve this issue because it will reduce the size of the informal sector while encouraging the formation and expansion of formal firms (Rafael La Porta & Andrei Shleifer, 2014).

 Based on Rizki et al. research, Indonesia with its large informal sector in which 57 percent of the 125 million working population are informal workers (50% in the non-agriculture sectors since 2000), the transition from informal to formal jobs is very gradual and can be rapidly overturned by an economic crisis. Although, indeed, between 1996 and 2014, they found evidence that the informal sector seemed to shrink along with economic growth, however, it took a very long time. The results from the first job trend examination show individuals whose first job was as a low-tier informal (LTI) worker, almost half remained in that position through the next 8 to 19 years, and another 45 percent became low-tier formal (LTF) workers for at least one year. Their findings emphasize that the dual economy is divided between low-tier and high-tier employment, rather than informal and formal employment. Even if they shift, they are still at a low-level of employment. However, they have a relatively good chance of switching to LTF work because of the earnings premium that LTI could gain is large and statistically significant (42%). Hence, the research recommends, instead of creating policies that try to encourage low-level informal sector workers to become high-tier informal sector workers – as most policymakers in developing countries desire, the government should be advised to create jobs, even if low-tier ones, that LTI can apply for.

Another research from William, Horodnic, & Windebank (2017) on the dual informal labor market with a case study in the European Union. They see the informal economy both as the ‘exclusion’ and ‘out’, and as internal dualism of it. The evaluation was carried out on a dual informal labor market composed of an exit-driven ‘upper tier’ and exclusion-driven ‘lower tier’ of informal workers. Their analysis resulted in the finding that 24% of participants did so for pure exclusion reasons, 45% for pure exit reasons, and 31% for a mixture of both exclusion and exit rationales. So, it is not purely for exit or exclusion rationales, instead, there is an internal dualism of the informal sector, with some involved in the informal sector being exit, others exclusion, and yet others driven by a mixture of both motives. However, the weight given to exit and exclusion is not uniform across the European Union. Exclusion is more common in Southern Europe and East-Central Europe but less in Nordic nations and Western Europe. Based on their analysis, the exclusion-driven ‘lower tier’ was identified as more likely to be populated by the unemployed and those living in East-Central Europe, and the exit-driven ‘upper tier’ by those with fewer financial difficulties and who live in the Nordic countries. In sum, the informal sector is not purely a necessity-driven realm for excluded populations or purely a result of a desire to exit a burdensome and over-regulated formal sector, it is a mixture of both exclusion and exit rationales.

Institutional Perspective

In addition to examining the phenomenon of the high percentage of informal employment in developing countries through the perspective of economic literature, the author will also look at it from an institutional perspective. Williams & Harodnic (2015), through the lens of institutional theory, reveal that there is a strong relationship between tax morale and participation in the informal economy. The lower the level of tax morale, the higher the level of participation in the informal economy. They mention that not only formal institutions (codified laws & regulations) – government morality – define institutional strength (non-compliance; enforcement) but also informal institutions (societal morality) such as norms, values, and principles. So, in the case of the informal economy, they argue that there is an asymmetry between government morality and societal morality, thereby resulting in a large percentage of the informal economy. The finding (case: the UK population) is people who participate in the informal economy have significantly lower tax morale than those in formal ones.

Indonesia’s Informal Employment

Based on the literature reviews and theories above, the author observes that in the Indonesian case, the exclusion theory is not really relevant (directly) as a reason for the high percentage of the informal sector, especially since the period 2018-after the pandemic COVID-19 until now. During that period, the government amended and passed regulations that ease and facilitate access for MSMEs and workers to enter the formal economy. For instance, the central government has also reduced registration fees (Directorate General of Intellectual Property, Trademark) and business taxes (1% to 0.5%) (Directorate General of Taxes) which have been implemented since 2018, but participation in the informal economy is still large. There are still many informal economy actors who are reluctant to transform into the formal sector. They still assume that the procedure for formalizing (registration) their business is too complicated – and expensive, although the government has reduced and simplified registration. Even the registration of the Taxpayer Identification Number (Nomor Pokok Wajib Pajak/NPWP) – as a requirement for access to capital loans at the Bank, paying taxes, and reporting the Annual Tax Return (Surat Pemberitahuan Tahunan/SPT) can be done at the tax office or through the online site at pajak.go.id which incidentally makes it easier for the community (theoretically). On the other hand, the formation of the Job Creation Law No. 11/2020 (widely known as the “Omnibus Law”) should also support informal workers and MSMEs to shift, but this is not the case.

The high informal sector in Indonesia is more relevant viewed through a rational exit lens in which MSMEs (and workers) choose to be informal because the costs of formality are greater than its benefits. They assume that formalizing their enterprises (mostly small one) are costly and not worth the benefits they get. They have to pay business taxes (Article 2 (5) Law No. 36/2008 on Income Tax; Government Regulation (PP) No. 23/2018 on Income Tax) and have to deal with regulations related to employment (the Job Creation Law No. 11/2020), product certification, and they have to pay business taxes (Article 2 (5) Law No. 36/2008 on Income Tax; Government Regulation (PP) No. 23/2018 on Income Tax) and have to deal with regulations related to employment (the Job Creation Law No. 11/2020) and product certification, and procedures they find complicated and time-consuming to perform. Most of the MSMEs in Indonesia are small – and mostly run by the lower middle class. Lower middle-class informal actors prefer to remain in the informal sector because they enjoy benefits such as not having to pay taxes – but enjoy tax advantages, wage rates that are not limited by labor regulations, not spending time with registration and administration processes that they consider complicated, and other advantages of not following the rules.

So, the author sees this as more of a human capital and societal morality issue. Small businesses and workers in the informal sector are constrained to meet standards in the formal sector due to their low capacities, such as inadequate skills, low education, and lack of knowledge about technology-digitization, which indeed affects their mentality and performance (productivity, efficiency, marketing, management). This fact is in line with the dual economy theory of informality. Furthermore, from an institutional perspective, the informal sector is a matter of enforcement and societal resistance which requires changing the values and beliefs of the population by trying to harmonize regulations and soft policies, so that trust, self-regulation, and high commitment can grow. Hence, in its implementation, the government must have clear indicators for MSME development. MSME development programs must be synergized so that they do not run separately in each ministry/institution. It is necessary to map and differentiate in handling problems based on the size of MSMEs, worker skills, and class so that empowerment is carried out on target. In conclusion, besides the significance of the institution, meaningful enforcement effort and capacity from above and societal cooperation from below, are very important indicators to create a strong institution. Lack of enforcement capacity relative to societal resistance becomes one of the causes of the high percentage of the Indonesian informal economy. It is also important to pay attention to increasing skills in line with the needs of the labor market. It seems that what is important is no longer whether they become informal (which always has a negative connotation) or formal (good one), but how to empower those at the middle and lower levels so that their capacity and morale support economic growth and prosperity economically and socially.