Financial development and the shadow economy: A multi-dimensional analysis

Abstract

This study examines the influence of financial development (FD), along three dimensions (financial depth, financial access and financial efficiency) in two main sub-sectors (financial institutions and financial markets), on the shadow economy’s (SE) size. Several econometric techniques and estimation strategies were applied to a balanced panel data set of a global sample of 114 economies and three sub-samples (low and lower-middle-income economies (LMEs), upper-middle-income economies (UMEs) and high-income economies (HIEs)) for the period 2002–2015. First, nine financial indicators were found to minimise the SE. Interestingly, financial institutions, especially financial institutions’ efficiency, had a more significant effect on the SE than financial markets. Second, there was evidence that the non-linear nexuses between FD and SE were U-shaped for eight of the nine financial indicators, the exception being financial institutions’ efficiency. Third, financial depth and financial access had a positive impact on the SE in the short run, while financial institutions appeared to reduce the SE in the long run. Fourth, the negative effects of FD on the SE were noticeable in LMEs and UMEs and dominant in HIEs in the long run. The non-linear relationships were consistent in UMEs, despite some variations in LMEs and HIEs.