Identifying the Determinants of the Shadow Economy: The Role of Finance

Although the determinants of the shadow economy have been extensively studied in the literature, the role of financial development has still not been sufficiently explored, and research on developing countries is relatively limited. In order to fill the gap in the literature, through three studies, this dissertation empirically examines different aspects of the relationship between financial development and the shadow economy. The first study investigates the drivers of the shadow economy for the Baltic region from 2009 to 2019 using the Panel ARDL estimation method. PMG estimates show that a higher tax burden, greater financial development, and financial institutional development lead to the expansion of the shadow economy in the Baltic region. The findings emphasize the role of institutional quality in reducing informal economic activities. The second study analyzes the determinants of the shadow economy for the CESEE region. For this purpose, a panel dataset containing annual observations for eleven CESEE countries for the 2003-2019 period was analyzed using panel FMOLS and DOLS estimation methods. Obtained empirical findings show that financial development and tax burden have a significant positive impact on the shadow economy. Besides, improvements in institutional quality, trade openness, and economic freedom help alleviate the shadow economy. The third empirical study examines our main research question for countries with the largest shadow economy. To assess the long-run relationships amongst the variables in a time series setting, conventional ARDL, and novel Fourier ARDL methods were applied. The long-run coefficients suggest that poor institutional quality results in the shadow economy expanding in low-income countries. However, advances in human capital assist in the reduction in the shadow economies’ size for all ten countries in our sample. A significant negative association between financial development and the shadow economy is observed for Peru and Thailand. Obtained findings indicate that institutional reforms should be the primary policy objective to shift activities from the shadow to the formal economy.