A Transaction Cost Analysis of Indonesia’s 2020 Job Creation Law
Why Lowering Barriers Alone is Not Enough
The 2020 Job Creation Law became one of the most important recent regulatory reforms in Indonesia. Despite successfully lowering barriers to formalization, the policy shows mixed results regarding growth among new firms. I contend that such evidence signals deeper constraints within Indonesian institutional arrangements.
The initiative highlights an ambition for institutional reform of the Indonesian labour market and is coherent within the theoretical frameworks of institutional economics. Coase underlines the implications of higher transaction costs related to information distribution, negotiation processes, contracting, and inspection as major reasons for transaction failure (Coase 1960:15). He argues that eliminating transaction costs is impossible and emphasizes government regulation as a mechanism to reduce transaction costs through its administrative power (Coase 1960:17). Hence, the reform presents itself as an effort to increase market efficiency by reducing regulatory frictions through a government initiative.
The initiative forces an adjustment to the structure of exchange that affects the cost of the transaction. Within a broader institutional framework, it signals the government’s intent to centralize the coordination and production for Indonesian firms. It is theoretically based on the idea about the motivations of firms, the regulatory and business environment, and ability of firms to act as economic agents (North 1990:34). The simplification of the regulatory framework reflects the confidence of the government towards these aspects, and in itself as an institutional body that provides a stable level of contracts for economic exchange.
However, transaction costs are only one of the many significant barriers to formalization. La Porta and Shleifer (2014) underscore several distinct factors that prevent effective formalization. They identify that better access to finance, land, and raw materials is the primary perceived motivation for formalization, compared to better opportunities with formal firms and fewer bribes. They also find that informality is persistent, anchored by the evidence that 91% of formal firms started out as registered (La Porta & Shleifer 2014:117).
Consequently, incentivizing formalization goes beyond simplifying transaction costs. De Mel et al. (2012:18) find that a higher level of formalization strengthens trust in the state, but recognize the importance of incentivizing firms to formalize beyond the simplification of regulatory procedures. They find that most firms in the informal sector are reluctant to formalize without additional incentives in the form of payments, due to concerns about labour taxes and land ownership (De Mel et al. 2012:7). Such evidence underscores the conditional nature of the impact of transaction costs on effective formalization.
For the Indonesian context, barriers to formalization are often more strongly associated with the firm’s side as opposed to regulatory constraints. Rothenberg et al. (2016) underline that tax avoidance and lack of intent to borrow from formal financial sources are the primary reasons for persistent informality amongst firms. Furthermore, they found that an Indonesian policy to reduce registration costs, namely the one-stop shops program, had an insignificant effect on informality rates, highlighting the low impact of regulatory simplification on formalization (Rothenberg et al. 2016:107).
Taken together, these studies show that the success of reducing transaction costs in promoting formalization is highly conditional on firms’ adaptability and motivation. Although regulatory frameworks aimed at simplifying administrative procedures may promote formalization and incentivize entrepreneurial activity, demand-side stimulus for informal firms are necessary to ensure productive outcomes. In the Indonesian context, these demand-side factors appear to be the most significant barriers to formalization.
The 2020 Job Creation Law focuses on providing a simplified regulatory framework for economic exchange to attract investment, create jobs, and stimulate growth. The initiative amends over 75 existing laws operated through several mechanisms, including licensing simplification, investment liberalization, and centralization of regulatory authority (UNCTAD 2020). The law simplifies the process of acquiring a risk standardization certificate, environmental assessment, permits, and licensing for firms. Notably, the government recentralized its authority to direct foreign investment policy for several sectors, including mining, power, forestry, public housing, and healthcare (UNCTAD 2020).
Although the law is in accordance with theoretical frameworks advocating for the minimization of transaction costs to enhance entrepreneurial activities, it becomes an example of misdiagnosis by failing to identify the necessary incentives to promote entrepreneurial activities. Its rushed lawmaking process also undermines the institutional credibility necessary for the enforcement of the newly formed policy.
The regulatory process is marked with flaws that undermine its credibility. The legislative process was unusually quick. The law was officially launched in October 2019 by President Joko Widodo, before being submitted to the parliament in February 2020. It was then passed by the parliament in October 2020. The quick process was formally attributed to minimize the circulation of COVID-19 among legislators, but critics viewed it as an effort to prevent mass labour mobilization against the law (Mahy 2022:61-62). The controversial extends to the enactment process, with the government requiring immediate enactment within three months after the law was passed.
In addition to the procedural imperfections, the law reveals the institutional constraints that limit the effectiveness of transaction cost reduction for productive formalization. Noticeably, the regulatory reform had downgraded key labour provisions from law to government regulation (Mahy 2022:64). Such adjustment significantly extends the power of the government by removing some laws from the oversight of constitutional court. North (1990:59) illustrates this dilemma by underlining the self-interest of the third-party enforcement at the expense of society, undermining the institutional credibility that firms requires to interact with the new economic arrangements.
Figure 1 Trend of business density rate (World Bank 2024)
Empirically, the initiative reveals the gap between the law’s objectives and its outcomes. The registration numbers for firms’ formalization were significantly impacted, displaying a sharp rise in the business density rate from 0.38 to 0.98 (World Bank 2024). At the same time, according to BPS data reported by Kompas, informal employment increased from 74.08 million people (57.27%) in February 2019 to 78.14 million (59.62%) in February 2021, and continues to rise up to 86.58 million (59.40%) by February 2025 (Mediana 2025). This pattern illustrates that reducing transaction costs would not be effective without maintaining institutional credibility and creating incentives for firms to formalize.
Collectively, the 2020 Job Creation Law displays the limitations of understanding transaction costs as the primary constraints towards entrepreneurial activities. While it aligns with institutional economic frameworks that emphazise reducing transaction costs, it fails to address demand-side constraints that incentivize firms to formalize and expand. The phenomenon of persistent informal employment after the regulation was imposed suggests that lowering transaction costs alone is insufficient incentive for formalization, and perhaps risks deprioritizing factors such as access to capital and tax concerns for firms.
The government identified administrative inefficiency and regulatory concerns as barriers to entrepreneurial activities. While correct, it overemphasized the significance of transaction costs while underestimating the importance of alternative incentives. Consequently, many firms remain within the informal sector despite facing lower registration costs.
The rushed legislative process also undermined the institutional credibility necessary to sustain the regulatory framework itself. Although the reform attempted to create more efficient coordination, the procedural faults weakened the trust for government and implicate the stability necessary for the new arrangements. Hence, the initiative became paradoxical: while enacted to reduce transaction costs, it weakened the institutional foundations for effective transaction-cost reduction.
The institutional constraints and demand-side considerations shape a coherent perspective regarding the limitation of transaction costs towards entrepreneurial activity. The regulatory framework in relation to transaction costs should be based on the institutional environment and firms’ regional characteristics. Reducing procedural barriers means little when firms see no advantage in formalizing, and Indonesia shows that in absent of such sensitivity, transaction cost reduction becomes a wasteful exercise with limited effect.
The 2020 Job Creation Law, therefore, shows that transaction costs should be understood as one of many obstacles to growth. Policies should move beyond administrative simplification and incorporate aspects such as institutional trust, productive incentives, access to finance, and long-term demand-side development. Without such consideration, deregulation risks increasing the quantity of formalized firms without substantially improving the quality of economic activity or sustaining a long-run economic transformation.
References
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