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Financial Development and the Underground Economy

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  • Keith Blackburn
  • Niloy Bosey
  • Salvatore Capasso

    ()
    (Centre for Growth and Business Cycles Research, Economic Studies, University of Manchester)

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.

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Bibliographic Info

Paper provided by D.E.S. (Department of Economic Studies), University of Naples "Parthenope", Italy in its series Working Papers with number 5_2008.

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Length: 21 pages
Date of creation: May 2008
Date of revision:
Handle: RePEc:prt:wpaper:5_2008

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References

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Cited by:
  1. Guerino Ardizzi & Carmelo Petraglia & Massimiliano Piacenza & Friedrich Schneider & Gilberto Turati, 2013. "Money Laundering as a Financial Sector Crime. A New Approach to Measurement, with an Application to Italy," Working papers, Department of Economics and Statistics (Dipartimento di Scienze Economico-Sociali e Matematico-Statistiche), University of Torino 018, Department of Economics and Statistics (Dipartimento di Scienze Economico-Sociali e Matematico-Statistiche), University of Torino.
  2. Giovanni Immordino & Francesco Flaviano Russo, 2014. "Taxing Cash to Fight Collaborative Tax Evasion?," CSEF Working Papers, Centre for Studies in Economics and Finance (CSEF), University of Naples, Italy 351, Centre for Studies in Economics and Finance (CSEF), University of Naples, Italy.

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