Structural Change and Formal Sector Employment Growth in Indonesia.

• Author: Pratomo, Devanto Shasta

The study provides evidence on the transition and growth of the formal sector in the Indonesian economy. It utilizes data from the National Labour Force Survey (Sakernas) for tracking the previous work status of labourers as formal or informal workers. The study also examines the implications of formalization of employment for the different rates of earnings of formal sector workers, given their human capital characteristics and different industries of employment. The study finds that the growth of employment in the formal sector is mainly the result of the entry of younger and better educated workers. Although there is some mobility from the informal to the formal sector, the results show that individuals who were previously working in the informal sector are less likely to move to the formal sector. In terms of earnings, there is evidence of scarring effects: individuals who are initially in the formal sector earn more than individuals who are initially in the informal sector.

Keywords: Informal sector, job mobility, human capital, earnings differentials, Indonesia.

Article received: August 2021; revised: February 2022; accepted: April 2022

1. Introduction

   The formal-informal dichotomy is of great significance in the study of structural transformation and economic development in developing economies. From a dual-sector perspective, the formal and informal sectors are fundamentally different. The informal sector tends to be more traditional, less productive, using little capital, and adding less value to the economies. In contrast, the formal sector, often the modern part of the economy, is the more productive sector with a more educated and more skilled labour force (La Porta and Shleifer 2014). Thus, a large difference in labour productivity between formal and informal parts of the economy is typical in developing societies (McMillan and Rodrik 2011). Employment in the informal sector is also characterized by insecure working arrangements, little protection for workers, and low wages (La Porta and Shleifer 2014; Rothenberg et al 2016).

   The structural transition from the informal sector into the formal sector has been considered a key driver of economic development (see Lewis 1954; Fei and Ranis 1964; Chenery 1979). In China, India and some other Asian countries, the transition has also been characterized by the expansion of higher productivity employment in the formal sector, mainly from the low-productivity agriculture into modern manufacturing and services. Structural change of employment from the informal to the formal sector has also contributed significantly to economic growth (Brandt, Hsieh and Zhu 2008; Herrendorf, Rogerson and Valentinyi 2014; and McCaig and Pavcnik 2015).

   Similar to other developing countries, the Indonesian labour market is divided between formal and informal sectors. Although the informal sector tended to be dominant in providing employment in the earlier decades, the labour market has undergone a fundamental transition, while at the same time employment has fallen in agriculture and stagnated in the non-agricultural informal sector (Figure 1. (1)

   Using the individual data from the National Labour Force Survey (Sakernas), this study seeks to provide an understanding of the labour market transition between formal and informal sectors, particularly focusing on the growth of formal sector jobs in Indonesia. As mentioned by McCaig and Pavncik (2015), workers who switch to the formal sector tend to have similar education, age, residence, and other characteristics to those already employed in the formal sector. Therefore, individuals who are poorly educated, older, female, and who are living in rural areas have a lower probability of moving to the formal sector. Besides the potential mobility of workers from the informal sector into the formal sector, Suryahadi, Marshan and Indrio (2018) also noted that the growth of formal sector employment in Indonesia, particularly in urban industry and services, is also supported by the employment of more younger, educated workers, who are mostly new entrants to the labour market. Using data from the Indonesian Family Life Survey, they showed that only a quarter of new entrants to the formal sector started work in rural agriculture; while almost half of new entrants to formal jobs had had prior access to non-agriculture sectors, and most chose the urban formal sector as their first place of employment.

   This study then continues to examine the implication of these transitions for earnings among the job movers. Although it contrasts the analysis of formal and informal sector earnings, the paper will focus more on the analysis of earnings in the formal sector, given that the earnings of the informal sectors tend to be variable from year to year in Sakernas. Besides showing that earnings in informal sector employment tend to be lower than in formal sector employment, previous studies in Indonesia suggest that the longer someone has a job in the informal sector, the more likely they are to be disadvantaged in terms of earnings compared with jobs utilizing labour with a similar qualification in the formal sector (Naidoo, Packard and Auwalin 2015). In other words, the evidence suggests "scarring" effects in terms of earnings from the experience of working in the informal sector, compared to movers with no experience in the informal sector or new entrants (see Manning 2018). (2)

   The following section of the paper looks briefly at the definition of the informal sector and then at the growth and share of formal-informal sector employment in Indonesia in more detail. Then, we discuss job mobility across sectors with a focus on mobility to the formal sector. The paper subsequently examines earnings differentials among the job movers, with a focus on the earnings of formal sector employees. Finally, the last section concludes.

2. Defining the Formal-Informal Sector

   The data used in the study are individual data, mostly from the National Labour Force Survey (Sakernas), covering the period from 2010 to 2017. To examine changes over time, the formal and informal definition used in the study is mainly based on the Central Bureau of Statistics (BPS) definition using work status categories (the so-called Proxy 1). Individuals are defined as working in the informal sector if they are self-employed, casual workers, or family workers, while wage employees and employers are categorized under formal sector employment. The concept of formal-informal sector used in the study, therefore, focuses on the labour market (employment) approach rather than the industrial or firm-based approach (see, for example, Rothenberg et al. 2016 for the latter approach). These categories are generally consistent with the standard practice of labour market definition of the formal-informal sector used in the literature on developing countries. (3)

   Following the practice of early authors on the subject (e.g., Hart 1973; Mazumdar 1976), we discuss the informal sector mainly in relation to non-agricultural work. In Indonesia, the main dynamics of the labour market for the past several decades have involved a shift of workers from agriculture to nonagricultural sectors, into both the formal and the informal sectors. While non-agricultural work was initially widely distributed in urban and rural areas, more recently it has become much more concentrated in the former--in the growing towns and cities.

   There are two main reasons for this approach. The first is simply statistical. A very high proportion of all work in agriculture (close to 90 per cent in urban and rural areas) is informal, as defined here, and this industry dominates the patterns and trends in informal work in the economy as a whole. However, for policy purposes, our main interest in the informal sector lies in raising productivity, which is measured by output per employment, mostly in non-tradeable service industries. Raising agricultural productivity involves a different set of policy options. Second, the nature of many informal enterprises in the agricultural sector is very different in one key respect from many of those outside agriculture: the self-employed in agriculture own or rent (or share-farm) a valuable asset, whereas most non-agricultural workers in the informal sector own very few fixed assets.

3. Growth and Structure of the Formal-Informal Sector

   The period chosen for examination covers a phase of growth of formal sector employment in Indonesia, which started in 2010 (see Figure 1). During the second decade of the 2000s, the share of formal sector employment in the country, supported by the growing formal-manufacturing and formal-services, rose from less than 30 per cent in 2010 to around 40 per cent in 2017. In contrast, the share of both formal and informal agricultural employment declined significantly from a total of 38 per cent in 2010 to less than 30 per cent in 2017, while the share of non-agricultural informal sector employment tended to be stable at around 30 per cent. (4) Related to the sector of activity, formal sector employees in Indonesia concentrated in manufacturing and services, while agricultural informal sector employees mainly worked in retail trade and small business.

   The growth of formal sector employment is important for Indonesia. This latest phase of structural change in the labour market implies that the country may have begun a little-noticed transformation away from the low productivity agriculture and informal sector into higher-value formal sector employment. Data presented in Figure 2 clearly show that, while up to around 2010 many jobs were created in the informal sector, it hardly grew after that, indicating that most new jobs had been created in the formal economy. One factor that is predicted to have influenced the transition to the formal sector has been the strong labour demand from services (Manning 2018), a pattern which is rather different from other rapidly growing...