From financial development to informality: a causal link

Salvatore Capasso (), Franziska Ohnsorge () and Shu Yu ()
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Salvatore Capasso: Rome and University of Naples Parthenope, Naples and CSEF University of Naples Federico II
Franziska Ohnsorge: World Bank
Shu Yu: World Bank

Public Choice, 2025, vol. 203, issue 3, No 10, 539-572

Abstract: Abstract Financial development reduces the cost of accessing external financing and thus incentivizes investment in higher-productivity projects that allow firms to reach the scale needed to operate in the formal economy. It also encourages participants of the informal sector to join the formal sector to gain access to credit and financial services. This paper documents two findings. First, countries with less pervasive informality tend to have greater financial development. Second, the impact of financial development, and especially banking sector development, on informality appears to be causal. This causal link is estimated using an instrumental variable for domestic financial development: financial development in other (neighboring) countries. The causal link between informality and financial development is stronger in countries with greater trade openness and capital account openness. The findings are robust to alternative specifications.

Keywords: Informal economy; Financial development; Cross-border financial integration; Emerging market and developing economies (search for similar items in EconPapers)
JEL-codes: E26 G20 (search for similar items in EconPapers)
Date: 2025
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DOI: 10.1007/s11127-024-01217-6

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