Financial development and the underground economy

Abstract

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 microeconomic 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.

The Shadow Economy in Palestine: Size and Causes

“…Many researches refer to direct and indirect tax and social security burden as the main cause of shadow economy increase (Capasso & Jappelli, 2013;Schneider & Enste, 2000;Schneider, 2010). If tax rates are high, workers will be discouraged to work extra hours for their employer's benefit, instead of that they may accept to work in a low part time job standards in order to evade paying tax and earn more income.…”

Informality: the Doorstep of the Legal System

“…Recent contributions on the informal economy also include: Sarte (2000), who studies the e ect of informality on growth in the presence of rent-seeking bureaucrats; Azuma and Grossman (2002), who show how the Government, in the presence of unobservable endowments, can extract from producers such a high amount to force the poorly endowed in the informal sector; Dessy and Pallage (2003), who propose a model with strategic complementarities where legal rms pay taxes that nance the provision of a productivity enhancing good; Fugazza and Jacques (2003), who develop a matching model of the labor market with formal and informal workers, showing that policies which encourage the participation in the legal sector are more e ective than deterrence; Busato and Chiarini (2004), who develop a business cycle model with a legal and an informal sector to stress the risk sharing opportunities allowed by the reallocation of labor supply across sectors; Maloney (2004), who studies the informal sector empirically in Latin America highlighting its entrepreneurial nature; Gerxhani (2004), who compares the informal sectors in developed and less developed countries; Choi and Thum (2005), who show how the option for an entrepreneur to produce illegally reduces the rents that corrupt public o cials can extract; Amaral and Quintin (2006), who show that informal rms substitute low-skilled labor for physical capital because of nancial constraints; Dabla-Norris, Gradstein and Inchauste (2008), who show, empirically, that the quality of the legal system is an important determinant of informality; De Paula and Scheinkman (2008), who build equilibrium models of informality and test them on a survey of Brazilian rms, showing that informality spreads along the supply chain in the presence of VAT collected with the credit system; La Porta and Shleifer (2008), who show, with survey data, that informal rms are ine cient, less capitalized and worse managed than legal rms; Blackburn, Bose and Capasso (2012), who highlight the trade-o between evading taxes and o ering collateral for investments, which means that the incentive to evade taxes is higher in less nancially developed countries; Capasso and Jappelli (2013), who also show, empirically, a negative relationship between nancial development and tax evasion as a consequence of the trade-o between tax evasion and the necessity to have collateral for investments; Ordonez (2014), who builds a general equilibrium model to show how incomplete tax enforcement decreases aggregate productivity and output.…”

Financial development and tax revenues in Turkey: A non-linear cointegration analysis

“…The limited number of empirical studies have generally performed the panel data analysis and revealed that financial development affected indirect and direct tax revenues positively (see Ilievski, 2012;Petrescu, 2013;Capasso and Jappelli, 2013;Taha et al, 2013;Bittencourt et al, 2014;Akçay et al, 2016). In one of the early studies, Ilievski (2012) investigated the impact of the banking sector, stock market and financial liberalization on tax revenues in more than 100 countries during 1990-2008 period using the panel data analysis.…”

“…Capasso and Jappelli (2013) also investigated the interaction between the shadow economy and financial development theoretically and empirically. Their theoretical model showed that financial development decreased the tax evasion level and shadow economy.…”