This paper reviews competing theories about the causes of informality in developing countries and uses new data to determine which theory best explains the persistence and scale of Indonesia’s informal sector. Using nationally representative survey data on micro, small, and medium-sized firms, the authors find that most of Indonesia’s informal firms are very small, micro firms, with less than five employees. These firms pay low wages, are relatively unproductive when compared to large firms, are managed by individuals with low educational attainment, predominantly supply products to local markets, and have not recently attempted to expand their operations.

From a small-scale, qualitative survey of firms, the authors find that many informal firms do not register their businesses either because they have no desire to expand or borrow from formal financial sources, or because they are avoiding taxes. Finally, they evaluate the impact of Indonesia’s one-stop-shops for business registration program, a large-scale program that attempted to reduce registration costs.

The authors find both that the program had no effects on firms’ informality rates, and they also find that it did not reduce the probability that workers were informally employed. Taken together, the evidence suggests that a combination of the rational exit and the dual economy theories best explains why so many firms in Indonesia are informal.