Working Paper: CEPR ID: DP16711
Authors: Salvatore Capasso; Franziska Ohsorge; Shu Yu
Abstract: A large literature has documented an inverse relationship between financial development and the size of the informal economy, with some evidence that the link is depends on the institutional environment. The direction of causality, however, remains a matter of debate, making it hard to identify the right policy interventions for better economic outcomes. This paper reviews this literature. Drawing on the theoretical literature, it sketches out the various channels through which financial development can influence firms’ choice to operate informally at all or the degree to which they operate informally, or vice versa. In addition, this paper summarizes the empirical evidence that, at the moment, does not settle the question of direction of causality in a broad sample of countries.
Keywords: informal economy; financial development; emerging market; developing economies
JEL Codes: E26; G20
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| Greater financial development (O16) | Reduction in the size of the informal economy (E26) |
| Reduction in the size of the informal economy (E26) | Greater financial development (O16) |
| Financial development reduces costs associated with formalization (O16) | Encouragement for firms to operate formally rather than informally (L26) |