DP16711 Informality and Financial Development: A Literature Reviews

Author(s): Salvatore Capasso, Franziska Ohnsorge, Shu Yu
Publication Date: November 2021
Keyword(s): emerging market and developing economies, Financial Development, Informal economy
JEL(s): E26, G20
Programme Areas: International Macroeconomics and Finance
Link to this Page: cepr.org/active/publications/discussion_papers/dp.php?dpno=16711

A large literature has documented an inverse relationship between financial development and the size of the informal economy, with some evidence that the link is depends on the institutional environment. The direction of causality, however, remains a matter of debate, making it hard to identify the right policy interventions for better economic outcomes. This paper reviews this literature. Drawing on the theoretical literature, it sketches out the various channels through which financial development can influence firms' choice to operate informally at all or the degree to which they operate informally, or vice versa. In addition, this paper summarizes the empirical evidence that, at the moment, does not settle the question of direction of causality in a broad sample of countries.