The shadow economy and sustainable development: The role of financial development

• Published date: 01 August 2020
• Date: 01 August 2020
• DOI: http://doi.org/10.1002/pa.2099
• Author: Asghar Afshar Jahanshahi,Behrooz Gharleghi

ACADEMIC PAPER

The shadow economy and sustainable development: The role

of financial development

Behrooz Gharleghi

1

| Asghar Afshar Jahanshahi

2

1

Universidad Católica los 

Angeles de

Chimbote, Instituto de Investigación,

Chimbote, Peru

2

CENTRUM Católica Graduate Business

School, Pontificia Universidad Católica del

Perú, Lima, Peru

Correspondence

Asghar Afshar Jahanshahi, CENTRUM Católica

Graduate Business School, Pontificia

Universidad Católica del Perú, Lima, Peru.

Email: afshar@pucp.edu.pe

Abstract

This paper provides fresh evidence concerning the threshold relationship between

the shadow economy and financial development. Shadow economy is quoted as an

obstacle to sustainable development and therefore the role of financial development

is examined in this paper to tackle the issue of shadow economy. It is based on panel

data of 29 developed and developing countries over the period of 1975–2015 and

use of panel threshold model. Three proxies for financial development—liquid liabili-

ties, private credit to deposit money banks, and stock market capitalisation—were

utilised to obtain the threshold value of US$33,600 Gross Domestic Product (GDP)

per capita. This threshold helps to determine the impact of financial development on

the size of the shadow economy. Empirical results suggest that above this threshold,

financial development significantly contributes to the reduction in size of the shadow

economy while it has no impact for countries that have per capita income below this

threshold. This implies that, countries with lower per capita income (below $33,600)

should implement policies to improve accessibility to finance and credit market which

leads to a sufficiently higher per capita income that in turn allows for a reduction in

the size of the shadow economy.

1|INTRODUCTION

Financial development is obviously an important indication of eco-

nomic development in each country (Aizenman, Jinjarak, & Park, 2015;

Calderón & Liu, 2003; Christopoulos & Tsionas, 2004; Menon, 2019a).

However, the shadow economy is a major obstacle for economic

growth especially for developing countries (Akadiri, Gungor, Akadiri, &

Bamidele-Sadiq,2019; Gharleghi, Jahanshahi,& Thoene, 2020; Menon,

2019b). The recent data suggest that the size of the shadow economy

varies from 15 to 40%for developed and developing countries, respec-

tively (Bitzenis, Vlachos, & Schneider, 2016; Schneider, 2007, 2011).

These figures are 15 and 33.6% for the countries considered in this

study. The causes and effects of the shadow economy have been a

topic of extensive research which is documented in the literature

(e.g., Bose, Capasso,& Wurm, 2012; Capasso & Jappelli, 2013; Menon,

2019a, 2019b;Schneider & Enste, 2000).

The shadow economy weakens a government's ability to generate

revenue that is vital for providing public goods and developing

infrastructure (Gërxhani, 2004; Schneider, 2007). It can further slow

the investment rate and affect the allocation of real resources and

hinder growth. The role of financial development is to reduce the neg-

ative effects of the informal economy. This is achieved through lower-

ing the barriers to obtaining credit—especially for entrepreneurs—and

raising opportunity cost of production in the underground economy

and thus incentivising informal firms to move to the formal economy

(Capasso & Jappelli, 2013).

In a study by Berdiev and Saunoris (2016), the dynamic relation-

ship between financial development and the shadow economy was

examined for a set of 161 countries over the period from 1960 to

2009. Using a panel vector autoregressive model, it was found that

financial development reduces the size of the shadow economy.

A study of the impact of financial development on the shadow

economy of Malaysia was carried out by Habibullah, Din, Yusof-Saari,

and Baharom (2016) who found a nonlinear inverted-U shape rela-

tionship, which indicated that a higher (or lower) level of financial

development corresponds to lower (or higher) level of size of the

Received: 28 November 2019 Revised: 4 January 2020 Accepted: 14 February 2020

DOI: 10.1002/pa.2099

J Public Affairs. 2020;20:e2099. wileyonlinelibrary.com/journal/pa © 2020 John Wiley & Sons, Ltd 1of6

https://doi.org/10.1002/pa.2099