# **1. Introduction**

1. **Informality is a broad development challenge with multiple features and different layers of analysis.** Informality is associated with many development challenges, such as lower productivity firms, less protected workers, and tax leakages (Loayza 2018; Ohnsorge and Yu 2021; Ulyssea 2020). At the same time, the informal sector provides livelihoods, creativity, and buffers against shocks. The latter was exemplified by the recent shock induced by the COVID-19 pandemic. Despite the significance of informality in emerging markets and developing economies (EMDEs), it remains difficult to measure and study, mainly due to the presence of multiple definitions for informality and the lack of estimates (Elgin et al. 2021a). This is particularly the case in Indonesia where a limited number of  studies have focused on the informal sector.<sup>1</sup>

2. **Against this backdrop, this paper uses several novel datasets and various modeling approaches to measure the extent and nature of informality in Indonesia.** It first briefly summarizes the literature, discusses the multiple existing definitions of informality, and adapts the cross-country analytical framework on informality to the context of Indonesia. It then uses several novel datasets, including an updated cross-country database on informality provided by Elgin et al. (2021a), and a range of modeling approaches to capture the levels and trends of both output and employment informality. It further contributes to the existing literature by estimating output and employment informality in Indonesia at the regional, provincial, and sectoral levels, using a series of labor force surveys (SAKERNAS surveys) provided by Badan Pusat Statistik (BPS). Those estimates were then benchmarked to the levels, trends, and features in EMDEs to examine whether the major features of the informal sector in Indonesia deviate from those in EMDEs.

3. **Despite the recent development, informality remains pervasive in Indonesia.** While being slightly lower than the average of other EMDEs, output informality in Indonesia averaged around 35 percent of GDP in the decade before 2020, slightly above the average level in East Asia and the Pacific region (EAP). Informal employment in Indonesia, amounting to more than half of total employment, is higher than the average levels in other EMDEs and the EAP region. Like in other EMDEs, Indonesia witnessed a general declining trend in both output and employment informality during the past few decades. Nevertheless, both informality indicators remain elevated and broadly above comparator countries, creating both development and policy challenges.

4. **The informal sector in Indonesia exhibits several features, some of which are commonly documented in the literature and seen in the informal sectors in other EMDEs.** First, informality in Indonesia is mostly concentrated in the agriculture and low-skilled service sectors, similar to what has been observed in other EMDEs. Second, it is associated with a higher level of poverty at the provincial level, in line with the existing literature. Combinig evidence at the macro and micro levels, there appear to be productivity, education, and salary gaps between formal and informal workers. Moreover, markets are not segregated as informal firms compete

> 1 Some of the existing literarture on Indonesia includes ADB (2010), Baddiet, Brown and Mazaheri (2015), OECD (2010), and Comola and de Mello (2011).

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