The Large Informal Economy in Indonesia: an institutional weakness?

Indonesia is one of the developing countries in Asia with a large number of Micro, Small and Medium Enterprises (MSMEs). In 2016, the Bureau of Statistics recorded that 99 percent of businesses in Indonesia could be classified as MSMEs and as many as 65 million MSMEs contribute 61 percent of the country’s total Gross Domestic Product (GDP) in 2020. However, unlike in its neighboring Malaysia or Vietnam, MSMEs in Indonesia are dominated by the informal sector. More than 60 percent of Indonesia’s workforce makes a living in the informal sector where most MSMEs operate (The Interpreter, 2021). In many developing countries, the informal economy does make a significant contribution to total economic activity, but in Indonesia, the percentage of its informal economy is very high. Several studies on the informal sector in Indonesia argue that this phenomenon occurs due to symptoms of poverty and poor economic growth, and somehow this high percentage has negative effects on state tax revenue, market structure, and competition. However, in this article, I will examine this phenomenon from the institutional perspective, whether the capacity issue or the actor’s behavior.

Based on BPS-Statistics Indonesia data (2022), the percentage of informal workers in Indonesia is 59.31% with the highest concentration in rural areas. Papua, West Sulawesi, and West Nusa Tenggara are the three provinces with the largest number of people working in the informal sector. The process of informalization of the economy and workforce in Indonesia has started to increase since the economic crisis that occurred in 1998 when the inflation rate was very high. The economic crisis pushed people to shift from the large industrial sector which depended on imported goods to the agricultural sector (village) and the service sector (city) due to layoffs. In this case, institutional weakness stems from economic instability so labor regulations that aim to improve the welfare of society cannot be implemented because of the low state’s capacity.

However, gradually the Indonesian economy is growing accompanied by progress in infrastructure and state capacity. Still, the government’s efforts to formalize the informal sector, especially MSMEs, which are the largest business actors in Indonesia, have not yet produced results. The Covid-19 pandemic that occurred in 2020 shook the condition of the informal economic sector because people’s purchasing power fell and government policies limited mobilization. Small businesses that are not touched by digitalization experience many difficulties in running their business. Therefore, from the government’s perspective, business formalization will greatly benefit entrepreneurs in terms of access to capital loans, a broad target market, coaching, certification, and so on, while for countries formalization can facilitate data collection and coordination, increase state revenues both from business taxes and increase production volume, increasing exports and accelerating national economic recovery.

Supported by the formation of the Job Creation Law No. 11/2020 (widely known as the “Omnibus Law”), MSMEs are encouraged to transform from informal to formal with the ‘ease’ of registering as MSMEs so that other facilities are easily accessible. Even the registration of the Taxpayer Identification Number (NPWP) – as a requirement for access to capital loans at the Bank, paying taxes, and reporting the Annual Tax Return (SPT) can be done at the tax office or through the online site at which incidentally makes it easier for the community (theoretically). In addition, the central government has also reduced registration fees and business taxes (1% to 0.5%) 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 assume that the procedure for formalizing (registration) their business is too complicated – and expensive, plus 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 and product certification. Digitalization efforts intensified by the central government also only reach middle and upper-middle-class entrepreneurs, while middle and lower actors who are technologically illiterate are increasingly experiencing difficulties. Lower middle-class informal actors also 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, do not spend time with registration and administration processes that they consider complicated, and other advantages of not following the rules.

Apart from the capability of informal sector businesses to meet the requirements of transformation to the formal sector, social norms & values greatly influence their decision to remain in the informal sector. For example, low tax morality, low public trust in the government, and administrative processes that they consider difficult because they are unfamiliar with technology/digitalization. Low public trust arises because, for example, state agencies target informal entrepreneurs such as ready-to-eat food which are considered not certified or meet standards, then are threatened with prosecution if they do not pay the authorities (The Interpreter, 2021). Such individuals impede government (national) efforts and discourage people from believing in government policies that genuinely want to empower informal entrepreneurs who need assistance. In line with the argument of the institutional weakness concept brought by Brink et al (2022), the state has the capacity – fiscal and administrative capacity – and enforcement has been carried out by the central government, but non-compliance comes from greater societal resistance.

The formal rules contradict dominant social values and principles. On the other hand, there are also many cases where bureaucrats or local governments (politicians) who are responsible for enforcement actually take advantage of their position and do not encourage formalization. Sometimes there are companies in the formal sector lobbying local governments or the bureaucracy to subcontract with informal companies so that they can outsource labor-intensive production to informal companies that do not comply with labor regulations and can circumvent other legal restrictions. In short, the high percentage of the informal economy in Indonesia is not caused by low state capacity financially or administratively, but rather low enforcement at the local level and an asymmetry between laws and regulations from formal institutions (government integrity) and norms, values, principles from informal institutions – societal morality.

Changing informal institutions or changing formal institutions?

In order to achieve economic development (from the state perspective) – and increased income and market expansion with reasonable cost (from the perspective of informal employers and workers), the question that arises is what is the balanced recipe (or at least works)? Changing informal institutions or changing formal institutions? Indeed, it 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. Making the benefits of transformation outweigh the costs of the formal economy. It requires procedural fairness in which society believes that the state agencies, tax authorities, or politicians treat them with responsibility, impartially, and respect. The orientation should shift from a ‘police & mugger’ approach toward a customer-service approach. Otherwise, if citizens feel they are being treated unfairly, this creates a lack of trust and resistance to compliance. Besides that, fairness is also needed where citizens believe that they pay their fair share compared to others. So, they tend to trust the institutions and organizations that enforce them, accept their decisions, and follow directions.

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. Providing easy-to-consume information about their responsibilities with regard to compliance as well as education about the value and benefits of formalization. For instance, by informing employers or employees about the risks and costs of the informal economy, the benefits of operating in the formal economy, and if there is an unforeseen disaster such as a pandemic, they can be better prepared. 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.

Ria Agustina Larasati
Ria Agustina Larasati
Graduate student at Gadjah Mada University, Indonesia. Online Freelance Writers and book editor at IRDH publishing.