Shadow economy, financial development and institutions: theory and evidence

This paper examines how financial development and institutional quality interact to influence firms’ incentives to participate in undeclared labour, thereby affecting the size of the shadow economy. Existing studies generally examine these factors in isolation, with insufficient focus on their interactions and the mechanisms connecting access to credit, institutional services, and firms’ labour decisions. To address this gap, we develop a stylized theoretical model that establishes a direct link between the decision to hire informal labour, access to credit and the quality of the institutions involved. We test the theoretical predictions using cross-country data from 1996 to 2017 for a large sample of different countries. To deal with endogeneity issues, we use an instrumental variable approach. The findings indicate that financial development markedly diminishes the magnitude of the shadow economy, with institutional quality serving as a crucial moderating factor that amplifies the efficacy of financial development in fostering formalisation. The results also show that finance and institutions may act as complements or substitutes, depending on the starting conditions. These results indicate that policies designed to diminish informality should integrate financial development and institutional reforms, with priorities differing amongst countries based on their specific institutional and financial circumstances.