Shrinking the Shadow Economy: Experimental Insights into the Role of Financial Development

Abstract

In this experiment-based study, we examined how development in the financial sector influences people’s propensity to participate in the shadow economy. We used a within-subject and between-subject design to examine the impact of various shadow economy structures, with a focus on the credit supply as a common proxy for financial development. Our research shows that people are more likely to operate in the formal economy when the level of financial development is higher, even if it associated with higher tax rate. We also found that the structure of the shadow economy affects people’s propensity toward it only when financial development is sufficiently advanced to create certainty in receiving credit.