Spillover effects of financial development on the informal economic activity

Purpose - This study aims to investigate the role and spillover effects of the financial sector on the size of the informal economic activity in Turkey. Design/methodology/approach - Time series analysis has been adopted for annual data of the 1970-2017 period. New approaches in unit root and cointegration tests have been used in this study. Estimations have been done via dynamic ordinary least squares and fully modified ordinary least square approaches. Findings - Results confirm the existence of a long-run equilibrium relationship between the financial system and informal economic activities in Turkey. At the earlier stages of financial development (FD), informality tends to rise while in further stages, informality tends to decline over time. This study confirms the U-shaped relationship between FD and the informal economy in Turkey. Research limitations/implications - This study has used logarithmic values of series in the econometric analysis except for real interest rates because of negative values in some periods. Thus, by using level forms of real interest, missing values would be avoided. Practical implications - Increasing efficiency, control and institutional quality, as well as the quality of governance environment, would be useful tools in reducing the size of informality, as this study finds that spillover effects of financial services on the informal economic activity are adverse. Originality/value - This study is the first of its kind to the best of the knowledge in the case of Turkey, which estimates the spillover effects of FD on informal economic activity.