A General Equilibrium Model of Formalization in a Dualistic Economy with Evidence from Indonesia

Informal-sector employment is pervasive in developing economy cities. The informal sector contributes little to public finance and has low productivity due to the lack of access to trade support and export market, which is available in the formal sector. We study cross-region variations in employment formalization within a country in a general equilibrium model where entrepreneurs in each region choose between the formal and informal sectors by weighing the benefit of access to export market and the cost of a local business tax. The model is built on Behrens, Duranton and Robert-Nicoud (2014) to account for (1) skill sorting across regions; (2) occupation selection in terms of employee, informal-sector entrepreneur, and formal-sector entrepreneur; and (3) agglomeration economy arising from home-market effect. We solve for equilibrium employment size and number of entrepreneurs and their skill mix in both formal and informal sectors in individual regions, subject to perfect labor mobility and national aggregate employment and skill endowment constraints. The model can account for the cross-region variations in these equilibrium employment variables observed in Indonesia during the past two decades. The counterfactual analysis shows how employment and skills shift between the employment sectors and regions in response to export improvement and business tax changes.