Financial development and the underground economy

a r t i c l e i n f o We provide a theoretical and empirical study of the relation between financial development and the size of the underground economy. In our theoretical framework agents allocate investment between a low-return technology which can be operated with internal funds, and a high-return technology which requires external finance. Firms can reduce the cost of funding by disclosing part or all of their assets and pledging them as collateral. The disclosure decision, however, also involves higher tax payments and reduces tax evasion. We show that financial development (a reduction in the cost of external finance) can reduce tax evasion and the size of the underground economy. We test the main implications of the model using Italian microeco-nomic data that allow us to construct a micro-based index of the underground economy. In line with the model's predictions, we find that local financial development is associated with a smaller size of the underground economy, controlling for the potential endogeneity of financial development and other determinants of the underground economy. Recent estimates indicate that the underground economy represents 10–15% of GDP in developed countries and 30–40% in developing countries. In some countries, such as Panama and Bolivia, almost 70% of GDP is hidden (Schneider, 2007). Apart from ethical and political concerns, a large share of underground economy is a serious issue for governments and policy makers since it distorts investments, exacerbates income inequality, and hampers growth. 1 Many factors explain the emergence and size of informal activities. A high level of taxation, a cumbersome legislation, high payroll taxes and labor costs are only some of the many factors which may push firms into informality. Among these factors, the availability of credit and its cost have received little attention. In this paper we study how the choice to operate underground (and to what extent) interacts with financial development. As in Ellul et al. (2012), the starting point of our analysis is that the ability to reveal and signal revenues reduces information frictions and the cost of credit. When firms or individuals operate underground their ability to signal revenues and assets is lower, and the cost of credit higher. As financial markets develop, more efficient intermediaries enter the market and the cost of credit falls, increasing the opportunity cost of continuing to operate underground. In short, financial market development is negatively correlated with the size of the …