Financial development and the shadow economy: A panel VAR analysis

This paper examines the dynamic relationship between financial development and the shadow economy using data for 161 countries over the period 1960-2009. Specifically, we use a panel vector autoregression model to construct impulse response functions that illustrate the time path of one variable (e.g., the shadow economy) following an orthogonal shock to another variable (e.g., financial development). We find that financial development reduces the size of the shadow economy. Moreover, there is some evidence of reverse causality between these variables; namely, a shock to shadow economy inhibits financial development.