Does financial stability matter in reducing the shadow economy? Perspectives from emergent and non-emerging economies

This paper utilizes data from a sample of 148 emergent and non-emergent economies to examine the relationship between the stability of the financial sector and the size of the shadow economy. To undertake our empirical investigation, three alternative estimators have been employed, namely fixed effects generalized least squares (FEGLS), instrumental variable (IV) and generalized method of moments (GMM). The findings of this study indicate that greater financial sector stability has a substantial impact on the size of the shadow economy. Depending on the estimator employed, the findings of the present study indicate that a 10% rise in financial stability is associated with a decline in the size of the shadow economy ranging between 0.06% and 0.58%. From a policy perspective, the findings of this study suggest that policymakers can play a key role in affecting the incentives of economic agents to join the formal economy by enhancing the stability of the financial sector and, consequently, financial inclusion.