Abstract
This study investigates the relationship between financial development and the size of the informal economy. We build a model in which an exogenous variation in the size of the informal sector creates two effects on financial development. Specifically, informal sector harms financial development through increasing financial repression due to tax evasion. However, on the other hand, increasing informal sector size facilitates financial development through easing the capacity constraint on the financial sector. Using a cross-country panel data set of 152 countries over the period 1999–2007 we also provide empirical support for the mechanism of our theory.
Highlights
Financial development is clearly an important indicator of the long-run macroeconomic development
There are many other open questions including even such basic ones such as whether informal sector size would be larger in low income or high income nations; whether taxes are positively correlated with informal sector size or not or whether shadow economy and corruption are substitutes or complements (Dreher and Schneider 2010)
Definition 2.1 The equilibrium of the economy is given by deposit and borrowing interest rates (r and R) and the endogenous unit cost of monitoring at which formal sector risk-averse entrepreneurs optimize endowment allocation choice between risky-investment and bank deposits (wI (c∗) and wE (c∗)), risk-neutral entrepreneurs optimize external finance, the capital market clears and the zero profit condition for the bank holds
Summary
Financial development is clearly an important indicator of the long-run macroeconomic development. In our model formal sector entrepreneurs pay taxes and borrow and lend in the financial market at an endogenous cost of external finance to insure against idiosyncratic production risk. Where the unit cost of monitoring cF endogenously determines the interest rate spread, or in other words the efficiency of the financial sector, in the economy In this environment risk-averse entrepreneurs supply the bank deposits. The interest rate spread r > R ensures that the risk-neutral entrepreneurs are net borrowers in the economy This qualitative feature of the model does not contradict with empirically observed firm-capital structure patterns: A large fraction of firm owners, including highly leveraged small and medium size enterprises, do not invest a large fraction of their personal assets in their own production units so that they could diversify idiosyncratic production risk. In our set-up informal sector entrepreneurs do not diversify production risk and invest 100 % of their personal asset holdings in their own investment projects
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