Taxing the Urban Informal Economy: The Case of Indonesia

This study endeavours to assess the magnitude of the urban informal economy (UIE) and to identify the major issues, opportunities and challenges associated with taxing the UIE, and so bring to the government’s attention tailored recommendations to bolster tax revenue. Employing a quantitative methodology, the study investigates and validates its models through a meticulous review of relevant literature. Therefore, the important contribution of this study is that it is not only the first comprehensive investigation of the size of the UIE across Indonesia based on regions but also provides a comprehensive exploration of the informal economy and taxation. The research utilises three models based on primary and secondary data from various sources, including individuals, businesses, and tax officers. The first model employs structural equation modelling (SEM), precisely the multiple indicators and multiple causes (MIMIC) method, to estimate the annual size of the UIE and potential tax in Indonesia during the research period from 2012 to 2018. The period aligns with the introduction of new taxation policies for micro, small, and medium enterprises in 2013 and ending in 2018. The research model revealed that UIE constituted an average of 18.57% of the gross domestic product (GDP), and the tax loss generated from the informal economy was equivalent to 6.6% of GDP. The method also analysed causal and indicator factors for UIE size. It identified that unemployment is the primary driver of the size of the UIE in Indonesia while noting the negligible impact of inflation and monetary circulation. The second and third models provide an econometric analysis to explore the most challenging factors and optimal strategies for taxing the UIE based on insights from UIE participants and tax officers. The findings highlight that cash-based transactions pose a significant challenge from the UIE perspective, whereas low taxpayer compliance emerges as a key concern among tax officers. Importantly, the second model underscores that formalising taxation within the informal economy potentially benefits in stimulating business, fostering economic development, and enhancing governance. The third model suggests that the Indonesian tax administration needs increased authority, autonomy, and flexibility in financing and managing human resources. This would enhance accountability and enable better tax collection from the informal economy. Additionally, the study recommends further research to develop institutional support for tax officials, aiming to capture and tax the hard-to-reach sectors of the economy effectively. Overall, these models furnish the Indonesian tax authority with invaluable insights for enhancing tax collection from the UIE.