What Determines Firms' Decisions to Formalize? - Empirical Evidence from Rural Indonesia

In this paper we analyze the decision of small and micro firms to formalize, i.e. to obtain business and other licenses in rural Indonesia. We use the rural investment climate survey (RICS) that comprises around 2500 nonfarm rural enterprises in six Indonesian districts and analyze the effect of formalization on tax payments, corruption, access to credit and revenue, taking into account the endogeneity of the formalisation decision to such benefits and costs. We show that, contrary to some of the literature, formalisation reduces tax and corruption payments. However, the benefits of formalisation, and therefore the likelihood of being formal, also depend on characteristics such as firm size, as well as the education and ethnicity of the owner.