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Financial Development and the Underground Economy

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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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Paper provided by Centre for Studies in Economics and Finance (CSEF), University of Naples, Italy in its series CSEF Working Papers with number 298.

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Date of creation: 28 Nov 2011
Publication status: Published in Journal of Development Economics, 2013, vol. 101, pp. 167–178
Handle: RePEc:sef:csefwp:298
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