The mutual effects of shadow economy and financial development in asean countries

SCHOOL OF ECONOMICS

INSTITUTE OF SOCIAL STUDIES

UNIVERSITY OF ECONOMICS

ERASMUS UNIVERSITY ROTTERDAM

HO CHI MINH CITY

THE HAGUE

VIETNAM

THE NETHERLAND

VIETNAM - THE NETHERLANDS PROGRAMME FOR M.A.
IN DEVELOPMENT ECONOMICS

THE MUTUAL EFFECTS OF SHADOW ECONOMY AND
FINANCIAL DEVELOPMENT IN ASEAN COUNTRIES

by Nguyen Hoang Phu
A thesis submitted in partial fulfilment of the requirements for
the degree of

Master of Art in
Development Economics

Ho Chi Minh city, January 2018

VIETNAM - THE NETHERLANDS PROGRAMME FOR M.A. IN
DEVELOPMENT ECONOMICS

THE MUTUAL EFFECTS OF SHADOW ECONOMY AND
FINANCIAL DEVELOPMENT IN ASEAN COUNTRIES

by Nguyen Hoang Phu
A thesis submitted in partial fulfilment of the requirements for
the degree of

Master of Art in
Development Economics

Academic Supervisor:
Dr. Pham Thi Thu Tra

Ho Chi Minh city, January 2018


DECLARATION
I hereby declare that my dissertation entitled “THE MUTUAL EFFECTS OF
SHADOW ECONOMY AND FINANCIAL DEVELOPMENT IN ASEAN
COUNTRIES” is the result of my own work and includes nothing which is the outcome
of work done in collaboration except as declared in the Preface and specified in the text.
I also confirm that:
 This thesis was done wholly while in candidature for a research degree at
VNP;
 Where any part of this thesis has previously been submitted for a degree or
any other qualification at VNP or any other institution, this has been clearly

stated;
 Where I have consulted the published work of others, this is always clearly
attributed;
 Where I have quoted from the work of others, the source is always given.
 With the exception of such quotations, this thesis is entirely my own work,
and I have acknowledged all main sources of help.

Date: January 02, 2018

Signature .....................................................
Full name: Nguyen Hoang Phu


ACKNOWLEDGEMENT
This thesis cannot complete without the support of my supervisor, Dr. Pham Thi
Thu Tra, who has spent the value time, efforts, and energy to guide me on the thesis
during the time of completing the thesis. Her dedication made me motivated when I
have a chance to discuss with her, her expertise is what makes me impressive when I
ask her questions about my thesis’s topic, and she also kept me in the “can – do” attitude
when I faced any difficulties in doing thesis. All of these leave me with the most
unforgettable memory and experience. My purpose of this acknowledgement is to
express my gratitude to my supervisor. Without her supports, I may not have a chance
to pursue my dream.
I would like to send my special thanks to Prof. Nguyen Trong Hoai, Dr. Pham
Khanh Nam, Dr. Truong Dang Thuy for their valuable command, guidance and support
during the program. Without your support and encouragement, I may not complete the
thesis as expected.
Additionally, my thanks are given to all of the lectures who have been my
knowledge guiders and the staff who have been my service supporters throughout the
master program at University of Economics and Erasmus University Rotterdam.

Without their help, never can I have an opportunity to proceed and complete my master
thesis.
Last but not least, I would like to thank Mr. Nguyen Cong Thanh, Truong Thi Thu
May and my family who have always been a pillar for me to rely on during the hardships
of attempting to achieve the master thesis. It is their unspoken sacrifice and untiring
work that bring me more spare time to be able to reach the final destination of my
progress.


ABSTRACT
This study focuses on examining the mutual relationship between financial
development and shadow economy by applying the theoretical and empirical
framework. Our research contributed to the way of calculating the size of shadow
economy applied the currency demand approach with updated data from 1997 to 2015
for 8 ASIAN countries. In particular, to have a robust result, we used 4 estimation
methods including POLS, FEM, REM and SGMM to calculate the value of the size of
shadow economy of each country. Then, we took each received results to examine the
mutual effect with the financial development using P – VAR approach. We found that
when the positive shock caused by the financial sector affects the shadow economy, the
shadow economy will immediately respond negatively to the shock. On the other hand,
when a positive shock caused by credit for private sector will lead to the positive
responses of the shadow economy. Interestingly, in this case, the response tends to last
longer with the estimated results from static model of shadow economy in comparison
with dynamic model of shadow economy.

Keywords: Shadow economy, financial development
JEL classifications: G32, H26


TABLE OF CONTENTS

Chapter 1: Introduction ............................................................................................................... 11
1.1.

Problem statements ................................................................................................... 11

1.2.

Research objectives ................................................................................................... 13

1.3.

Scope of the study ..................................................................................................... 14

1.4.

Structure of the thesis ................................................................................................ 15

Chapter 2: Literature review ....................................................................................................... 16
2.1.

Review of theory ....................................................................................................... 16

2.1.1.

The theory of shadow economy ........................................................................... 16

2.1.2.

The review on financial development theories..................................................... 21

2.2.

Review of empirical studies on the relationship between financial development

theory and shadow economy theory ................................................................................................. 27
2.3.

Summary ................................................................................................................... 31

Chapter 3: Research methodology .............................................................................................. 34
3.1.

Analytical framework................................................................................................ 34

3.2.

Econometric models .................................................................................................. 36

3.3.

Data ........................................................................................................................... 40

3.4.

Variables and sampling ............................................................................................. 40

Chapter 4: Research results ........................................................................................................ 42
4.1.

Overview of the research topic ................................................................................. 42

4.2.

Descriptive statistics ................................................................................................. 44

4.3.

Regression results and discussions............................................................................ 45

Chapter 5: Conclusions ............................................................................................................... 55
5.1.

Conclusions ............................................................................................................... 55

5.2.

Limits of the study .................................................................................................... 56

Reference .................................................................................................................................... 58
Appendices ................................................................................................................................. 65


LIST OF TABLES

Table 1: Descriptive Statistics for the whole dataset...................................................... 44
Table 2: Matrix of correlation coefficients ..................................................................... 44
Table 3: Estimated results of currency demand model .................................................. 46
Table 4: Optimal model selection tests .......................................................................... 47
Table 5: Estimated value of Shadow economy over GDP ............................................. 48

Table 6: The results of Unit Root Test ........................................................................... 49


LIST OF CHARTS
Figure 1: Conceptual framework of shadow economy and financial development................. 31
Figure 2: The technical structure to deal with data .................................................................. 34
Figure 3: The analyzed results of impulse response function when the size of shadow
economic creates a shock with the estimated value of shadow economy from the
static models (POLS, FEM, REM) ........................................................................... 51
Figure 4: The analyzed results of impulse response function when the size of shadow
economic creates a shock with the estimated value of shadow economy from the
dynamic models (SGMM) ........................................................................................ 52
Figure 5: The analyzed results of impulse response function when the financial development
creates a shock with the estimated value of shadow economy from the static models
(PLOS, FEM, REM) ................................................................................................. 53
Figure 6: The analyzed results of impulse response function when the financial development
creates a shock with the estimated value of shadow economy from the dynamic
models (SGMM)) ...................................................................................................... 54


LIST OF APPENDICES

Appendix 1: Shadow economy estimation using POLS .......................................................... 65
Appendix 2: Shadow economy estimation using FEM............................................................ 65
Appendix 3: Shadow economy estimation using SGMM........................................................ 66
Appendix 4: Shadow economy estimation using REM ........................................................... 67
Appendix 5: Hausman Test ...................................................................................................... 67
Appendix 6: Breusch & Pagan Lagrangian multiplier test for random effects........................ 68
Appendix 7: Stationary test for shadow size estimated by POLS ........................................... 68
Appendix 8: Stationary test for first difference of shadow size estimated by POLS .............. 69

Appendix 9: Stationary test for shadow size estimated by FEM ............................................. 69
Appendix 10: Stationary test for first difference of shadow size estimated by FEM .............. 70
Appendix 11: Stationary test for shadow size estimated by REM ........................................... 71
Appendix 12: Stationary test for first difference of shadow size estimated by REM............. 71
Appendix 13: Stationary test for shadow size estimated by SGMM ....................................... 72
Appendix 14: Stationary test for first difference of shadow size estimated by SGMM .......... 72
Appendix 15: Stationary test for financial development measured by Credit for private sectors
........................................................................................................................... 73
Appendix 16: Stationary test for first difference of financial development measured by Credit
for private sectors .............................................................................................. 73
Appendix 17: Stationary test for financial development measured by Credit from financial
sectors ................................................................................................................ 74
Appendix 18: Stationary test for first difference of financial development measured by Credit
from financial sectors ........................................................................................ 74
Appendix 19: Stationary test for money supply ratio .............................................................. 75
Appendix 20: Stationary test for first difference of money supply ratio ................................. 75
Appendix 21: Stationary test for natural logarithm of GDP per capita ................................... 76
Appendix 22: Stationary test for first difference of natural logarithm of GDP per capita ...... 76


ABBREVIATIONS

POLS:

Pooled Ordinary Least Squared

FEM:

Fixed Effects Model

REM:

Random Effects Model


Chapter 1: Introduction
1.1.

Problem statements
According to World Economic Forum (2017), the shadow economy in some nations are

bigger than the official one. For instance, the shadow economy of Greece is about one – fifth of
its total GDP and right after is Italy (based on research by Germany’s Institute for Applied
Economic Research (IAW) at the University of Tübingen). Therefore, the activities related to
shadow economy may exist around the world. Many governments have tried to control shadow
economy by applying punishment, prosecution and even education. It is important for governor
of a nation to know about shadow economy’s activities and then they could make the economy
more efficient in terms of allocating resources. However, getting precise information about
shadow economy’s activities is hard, even with goods and labor working in the economy because
people tend to hide their activities’ in the market. Therefore, doing the research in this area
requires passion of the scientists and willing to explore “the unknown”. This is the first motivation
of author to research about this area.
Additionally, shadow economy is one of the main reasons that make the government
revenue for public goods reduce. Indeed, there are 75% of productions in developing countries
taken place underground while it is about 10% in developed countries (Enste & Schneider, 2000).
Entering the shadow economy, it means that the businesses and institutions can be out of the
control of the government and it called “fly under the radar” by Enste and Schneider (2000). Thus,
the shadow economy will undermine the ability of the government in building up the foundations
as well as the capacity of governments to collect the taxes (government’s income) for public
goods and other trading promotion programs (Enste & Schneider, 2000; Gërxhani, 2004). As a

result, the study about the shadow economy will touch many other areas and it will lead to a broad
research (Enste & Schneider, 2000; Gërxhani, 2004; Johnson, Kaufmann, & Shleifer, 1997;
Schneider, 2005, 2011; Tanzi, 1982). An intensive comprehension of the determinants of “secret
action” will help law - makers and governors in creating powerful strategies which can fight back
the uncontrollable exercises and encourage economic growth. Thus, this is the second motivation
for the author to study about this area.
To dig deeper in the field of this research, Enste and Schneider (2000); Gërxhani (2004);
Schneider (2005) stated that many other conducted studies found out that the difficulties in
accessing the credits, loans and the opportunity costs of these procedures are the main
determinants of shadow economy (Enste & Schneider, 2000; Gërxhani, 2004; Schneider, 2005).
Indeed, a country with strict assessments to have a loan or there are many barriers to open a new
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business will form a kind of foundations which is the origin of the initial shadow development
(Dreher, Kotsogiannis, & McCorriston, 2007; Friedman, Johnson, Kaufmann, & Zoido-Lobaton,
2000; Johnson et al., 1997; Teobaldelli, 2011; Torgler & Schneider, 2009). These organizations
(like commercial banks, financial institutions, insurance company, etc.) who will provide the
securities which can help the businesses to access the credit but they usually require the collateral
contract and in the case that a start – up business does not have assets, they have to deal with the
lack of credits and capital to operate their business in the early stage. As a result, they will seek a
new way to access the credit with lowest opportunity costs and it is the time for the development
of shadow economy. Furthermore, in the study of Vũ Việt Quảng and Lê Thị Phương Vy (2016),
they also showed that the ability of accessing to credit will contribute to the success of a business
and therefore this ability may affect the choice of a business to operate in the official economy or
shadow economy. The research of Nguyễn Thị Thùy Linh, Trần Huy Hoàng, and Nguyễn Hữu
Huân (2015) about the financial liberalization and the economic growth stated that the financial
development is the factor that fosters the financial liberalization and then economic growth, as a
result, it revealed that taking economic growth variable in the study should be considered.
As a result, the money related area is one specific kind of establishment that is probably

going to influence the spread of the shadow economy (Blackburn, Bose, & Capasso, 2012; Bose,
Capasso, & Andreas Wurm, 2012; Capasso & Jappelli, 2013; Dabla-Norris, Gradstein, &
Inchauste, 2008; Straub, 2005). In particular, the financial sectors serves numerous critical
capacities in an economy by giving business visionaries access to required credit, and allows
observing business exchanges for assessable purposes. Subsequently, money related
improvement raises the open-door cost of creating in the shadow economy by bringing down the
boundaries to acquiring credit, and along these lines, gives a motivation to casual business people
to move towards authenticity (Blackburn et al., 2012; Capasso & Jappelli, 2013). Moreover, to
the degree that the legislature can utilize the budgetary area to effectively screen and duty
exchanges, the advancement of the monetary segment brings down the events of assessment
avoidance, and accordingly, assist mitigates the spread of the shadow economy (Blackburn et al.,
2012; Capasso & Jappelli, 2013).
Recent researches about the topic done by Enste and Schneider (2000), and Schneider and
Enste (2013); Feld and Schneider (2010) are still controversial due to the disagreement of the
definition of shadow economy and the procedure of estimating as well as the uses of the estimates
in economic and policy analysis. In South East Asia, there were some researches on measuring
the size of shadow economies such as the study of Võ Hồng Đức, Lý Hưng Thịnh, and Tống Thị
Hồng Nhung (2015) researched on the field of shadow economy and also connected the concept
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of shadow economy with other factors such as the unemployment rate and economic growth
which is the motivation for the author to see another connection of shadow economy with other
factors. Indeed, in this research, the considered factor is the financial development which is
closely related to the economic growth (De Gregorio & Guidotti, 1995). However, the number of
researches on how shadow economy effects on other elements of the economy is still quite limited
and scarce. Thus, this thesis attempts to fulfil this gap by using updated data of 8 ASIAN countries
and self – estimating the value of shadow economy for each countries. Moreover, this research
will apply the same estimation technique with the research of Ardizzi, Petraglia, Piacenza, and
Turati (2014) and Enste and Schneider (2000) to estimate the value of shadow economy. Then,

we will apply various models such as POLS, FEM, REM and SGMM to test the relationship of
shadow economy and financial development to ensure the robustness of the results.
When we analyzed the relationship between shadow economy and financial development,
we found out that in the study of Straub (2005):


Increases in shadow economy decreases in financial development and economic
growth.

On the other hand, the study of Capasso and Jappelli (2013) they claimed that:


Increases in financial development  increases opportunity cost of producing in
shadow economy  easier for Government to tax  decrease the shadow
economy.

Our study will focus on these issues:


By applying the currency demand method, we will see how many percentage of
shadow economy over the total GDP of the overall researched countries?



What is the effect of the shock created by shadow economy on the financial
development and vice versa?



1.2.

Does the shadow economy have larger effect on financial development?

Research objectives
Our research objective is quite simple.

1. First, we will see the size of shadow economy over the total GDP in each research country.
2. Then, we examine the relationship between the shadow economy and financial
development by observing the shock created by shadow economy on the financial
development and the shock created by financial development on the shadow economy.
We see that

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2.1.Increases in financial development  increases opportunity cost of producing in
shadow economy easier for Government to tax decrease the shadow
economy.
2.2.Increases in shadow economy decreases in financial development and
economic growth.
Thus, we will examine the relationship based in the shock created by shadow economy and
financial development on each other.
Indeed, the shock created by shadow economy here in this research is considered as the
causes which will increase the size of the shadow economy such as the increase in taxation
(because this study focused on the shadow economy created by tax burden).
Moreover, the shock created by financial development in this research is considered as the
causes which will increase the financial development such as the increase in credit supply.
We do see the endogeneity in our model, but we will deal with it by using panel Vector
auto regression.

1.3.

Scope of the study
This study focuses on the two main concepts which are shadow economy and the financial

development. Therefore, we will analyze each concepts separately. Then we will conduct a review
on the empirical works of the two concepts.
Firstly, the concept of shadow economy will be covered from the definition to the indicators
of shadow economy and in this research, we will observe the shadow economy through the angel
of tax burden mainly. Therefore, we will apply currency demand approach to estimate the size of
shadow economy. Then, the financial development concept is also developed in the same way.
There is a discussion on the origin of financial development and how to measure the financial
development. After all of these discussions, the study will review some previous studies which
connect the two concepts.
For the employed model in the study, we followed the model of Tanzi (1983) to measure
the size of shadow economy for 8 – ASEAN countries. We also use the latest data for this study
(from 1997 to 2015). We choose 8 – ASEAN countries because in the study of Carter (1984),
Johnson, Kaufmann, and Zoido-Lobaton (1998) , Berdiev and Saunoris (2016) , they found out
that there are a huge difference in the size of shadow economy in developed and developing
countries. Additionally, the countries in the same region tend to have similar tax burdens and the
behavior of the regulation enforcement toward the shadow economy. The limitation in collecting
data is also the constraint when we choose 8 countries to study.
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Finally, to test the relationship between the two concepts, we use P – VAR method to see
whether the effect of shadow economy on financial development is negative or positive and vice
versa.

1.4.

Structure of the thesis
In chapter 1, we have a brief introduction about the topic shadow economy and financial

development. The importance of study in this field is discussed and the objectives of this research
is also mentions. Furthermore, to have a deep understand about the definition of shadow economy
and financial development, chapter 2 will have a very detailed discussion on these two concepts.
The authors reviewed all the relevant theories as well as the empirical works in chapter 2. After
the review on theories and empirical works, we come up with the methodology which we will
apply for this study in chapter 3. Moreover, chapter 3 will discuss about the analytical framework
and the econometric model which are used in our research. Data collection is also mentioned in
chapter 3. The results of this study is in chapter 4 which will show the regression results and the
discussion of the author. Finally, after receiving the research results, the author will come up with
some conclusions and also suggest the policy implications based on the author’s points of view
in chapter 5. Furthermore, the limitation of this research is also discussed in this chapter.
The detail of each chapter is below:


Chapter 1: Introduction



Chapter 2: Literature review



Chapter 3: Research methodology



Chapter 4: Research results



Chapter 5: Conclusions and policy implications

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Chapter 2: Literature review
This chapter will go through the review of all related theories of shadow economy and
financial development. Then, there is a review of empirical works regarding to the relationship
between 2 concepts: shadow economy and financial development. Finally, summary section will
provide an overview about the previous studies related to this field.

2.1.

Review of theory
This part will go through the concept of shadow economy and other theories related to

shadow economy which will help to see the main determinants of the shadow economy.
Furthermore, it also will have a little discussion about the causes of shadow economy in order to
have full understand of how shadow economy arises. After that a review on financial development
theories will be conducted to ensure the understanding of the origin of financial development
concept. Then, the determinants of financial development will be discussed.
2.1.1. The theory of shadow economy
The shadow economy is the general concepts which are to reflect economic activities in an
area that is contrary to the formal sector and is very important in the national economy.
Additionally, the definition of EU about shadow economy is that the economic activities that are
not recorded on statistical and quantitative network; furthermore, OECD states that activities

producing goods and services legally without declaring or producing unrelated goods and services
and intangible income are activities of shadow economy.
There are many studies on the existence of shadow economies such as Carter (1984),
Johnson, Kaufmann, and Zoido-Lobaton (1998) , Berdiev and Saunoris (2016) and many others.
These studies can be divided into two main groups: studies of shadow economics in developed
countries and studies in developing and underdeveloped countries. The fundamental difference
in approach of these two groups comes from the different chatter of underground activities. For
developed countries, the shadow economy is seen as an overlooked part of the national economy.
As for the developing and underdeveloped, the region is seen as an indispensable and integral
part of the national economy. This is also the reason why authors choose developing countries
for analysis in order to avoid mistakes about the nature of shadow economy in different levels of
national development.
According to Schneider (2011), the negative impacts of the shadow economy on the
economy are: tax-free, affecting government revenues, not counting on GDP, affecting statistics,
16


additionally, it may be the place where the illegal activities occur that affect the economy, culture
and society of the country and are not controlled by the state. In addition, the shadow economy
does not provide sufficient and accurate information for the proper planning of macroeconomic
policies, the effectiveness of policies, the effectiveness of state management, and the
effectiveness of the law are dismissed and disabled (Scott Hacker & Hatemi-J, 2008).
Furthermore, the shadow economy also makes businesses and their products less competitive at
the national level, and it is difficult to integrate into international trade to take advantage of the
opportunities offered by the associations and easily out of the international economic movement,
and become the periphery of development cooperation (Teobaldelli, 2011; Torgler & Schneider,
2009). Such an economy may push the nation backward in comparison with other nations or even
the region. The shadow economy also creates an unequal, untrustworthy and unfavorable business
environment for honest businessmen who are detrimental to the formal sector. Moreover, it
creates unstable factors which may risk the investment decision. The shadow economy also

discourages and promotes creativity, discourages long-term investment, large-scale investments
or human resources development. The shadow economy also limits the opportunities and the scale
of business due to the fact of the contributed capital mainly based on family relations, relatives,
and inability to promote the advantages of scale (Schneider, 2005). In particular, it may create
great public servants harassing, bribe and abuse power to serve the interests of individuals.
Obviously, the people working in the shadow economy do not have full social security coverage
(J. P. Choi & Thum, 2005). The shadow economy, however, is also the place where many
informal jobs are created, helping them earn a living and help the country survive a recession.
About the causes and effects of the development of the shadow economy, there have been
many discussions and studies, including Gërxhani (2004); Johnson et al. (1997); Schneider (2005,
2011); Schneider and Enste (2000); Tanzi (1982). These research papers suggest that the severity
of administrative procedures and taxation are the main causes of the development of the shadow
market, according to Gërxhani (2004); Johnson et al. (1997); Schneider (2005, 2011); Schneider
and Enste (2000). Furthermore, the shadow economy is also permitting individuals and
companies to operate under the "fly under the radar" observation of state agencies due to internal
weakness and weak management capacity of governments to provide mechanisms for
transparency of goods and services (Schneider & Enste, 2000)(Gërxhani, 2004).
Studies of Dreher, Kotsogiannis, and McCorriston (2009); Friedman et al. (2000); Johnson
et al. (1998); Teobaldelli (2011); Torgler and Schneider (2009) found that in high taxed and strict
17


policies countries increased the sensitivity of informal sector operations. Some state
administrative organizations take advantage of the high tariffs and the huge administrative
burdens that underlie the development of shadow economy.
In this study, the observations of shadow economy will be based mainly on the tax burdens.
Furthermore, in the study of Straub (2005) also stated that the barriers to access to public credit
will promote the increase of shadow economy. On the other hand, the support policies which
reduce the tax burdens will shrink the size of shadow economy. According to Elgin & Uras
(2013b), the increase (decrease) of shadow economy will lead to the decrease (increase) of

financial development. The opposite view of Capasso & Jappelli (2013) claimed that the increase
in financial development will lead to the smaller size of shadow economy. These two main
theoretical frame works will be discussed further in the section 2.2.
2.1.1.1.

Defining the Shadow Economy

Initially, it is difficult to define shadow economy concept until 1997, Smith (1997) offered
a new definition of shadow economy. He said that shadow economy was a kind of market – based
production of goods and services not in the estimation of official GDP regardless its legitimation
(legal or illegal). A broader definition is that all economic activities avoiding regulation and
taxation considered as shadow economy activities.
In this research, I follow the definition of shadow economy including all market – based
legal activities which are intentionally concealed by public departments or authorized institutions
due to any of these below reasons:
1. The payment of income and other taxes is evaded.
2. The payment of social insurances benefits is evaded.
3. To avoid committing labor legislation like minimum wages law, safety standards, benefits
for maternity, etc.
4. To not go through the complicated administrative procedures.
The concept of shadow economy in this research does not cope with illegal activities which
is also considered as shadow economy activities such as burglary, drug dealing, etc. Thus, these
points above are our very first assumptions about the shadow economy concept. In this research,
we just focused on the shadow economy created by the tax burdens. Thus, the currency demand
approach is the ideal choice for us to estimate the size of shadow economy (Epaphra, M., &
Jilenga, M. T., 2017).

18

2.1.1.2.

What causes the Shadow Economy?

2.1.1.2.1. Tax and other social products burdens
The first cause of shadow economy is tax and social insurance burdens which are also the
concern of economists around the globe. Indeed, taxes will affect the income of the labors
incrementally and the social insurance will take out some proportion from the income of labor.
Thus, the larger gap between gross income (before taxes and expenses) and net income (after
taxes and expenses), the higher portion of the development of shadow economy. Due to this
effect, taxes and social insurance burdens should be taken into account when measuring the size
of shadow economy.
To prove the effect of tax on shadow economy, there are many studies on that such as of
Del’Anno and Schneider (2005); Enste and Schneider (2000); Schneider (1994) and Friedman et
al. (2000); Johnson et al. (1998). All of these studies empirically provided evidences of the effect
of taxes (direct and indirect) on shadow economy. Furthermore, these studies also found evidence
of the effect of social insurance burdens on shadow economy.
Due to the complexity of taxation system across countries, the study of Buehn and
Schneider (2009) suggested a comparable proxies for tax and social insurance burdens. In details,
the proxy was constructed by these variables:
1. The proportion of direct taxes on total taxes.
2. Size of government: this variable will be built based on government expenditures.
3. Fiscal freedom: the data from Heritage Foundation's economic freedom index.
2.1.1.2.2. The level of regulations enforcement
The second cause of shadow economy is the rigidity of government regulations. If the
government manages economic strictly and then creates the barriers for business operations, it
will discourage the engagement of business in the official economy. Indeed, the “regulations”
comprises the labor laws such as minimum wages law or the protection of labors regulations, etc.,
the trade regulations such as quotas or tariffs. The empirical work of Johnson et al. (1998) found
out the effect of the regulations, especially the labor ones on the development of shadow

economy. Actually, if the government tightens the labor regulations, the labor costs will increase
and then it is the opportunity for the development of shadow economy because all the costs would
be shifted to the workers. Furthermore, this result also implies that the use of regulations or the
enforcement is the key elements for driving firms and also labor to shadow economy. In 2000,
Friedman et al. (2000) in their research, had the same result which stated that the relationship
between regulations and shadow economy was obviously positive. The research of Friedman et
al. (2000) also recommended that the government should improve the enforcement of regulations.
19


2.1.1.2.3. Public services
The government income will decrease due to the development of shadow economy which
affects negatively on the quality of public goods and services. Thus, to maintain the quality of
public goods and services, the government will tend to raise their income by increasing the taxes
imposing on the institutions and businesses in the official sector. These actions of the government
will push the business toward the shadow economy. The results from research of Johnson et al.
(1998) indicated that the country with lower tax rate and higher tax revenue, less regulations and
corruptions will have shadow economy with smaller size. Moreover, the nations with strong law
system respected by their citizens will have a smaller size of shadow economy. On the other hand,
especially transition nations are likely to have higher size of shadow economies because they tend
to have higher taxes (rates and revenue) on official sectors. In that research, they reached the
conclusion that a country with lower tax rate, having strong financial fundamentals and low
regulation burdens as well as good control of corruptions will have relatively smaller shadow
economy than others with counter – conditions.
2.1.1.2.4. Official economy
It is quite irony that official economy – itself is one of the reasons causing the shadow
economy. In various studies of Bajada and Schneider (2005); Schneider and Enste (2013); Feld
and Schneider (2010), the official economy will affect the choice of working or not working in
shadow economy of people and institutions. Indeed, when the economy is in the expansionary
state, the official economy will help to raise the opportunity costs of working in shadow economy

by providing good working conditions and facilitating the access to credits. However, when the
economy is in the recession state, the official economy will make the opportunity costs of
operating in shadow economy lower and thus it encourage people to move to shadow economy.
In order to observe these events, these below variables will be taken into account:
1. GDP per capita
2. Unemployment rate
These variables were used in the research of Feld and Schneider (2010).
2.1.1.3.

What identifies the Shadow Economy?

It is hard to measure the shadow economy directly. Thus, in order to measure the shadow
economy, the author has to calculate it indirectly by using the various indicators. In fact, there are
3 kinds of indicators which can be used to calculate shadow economy such as monetary indicators,
labor market indicators and the official economy indicators.

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2.1.1.3.1. Monetary Indicators
The medium of exchange in shadow economy is mainly in cash, all the transactions in
shadow economy have to be in cash in order to make sure that they are out of the control of “the
radar” and hence people cannot impose taxes on them. Therefore, the variable M2 should be
considered to use and the taxation variable T should be taken into account also (Ahumada,
Alvaredo, & Canavese, 2008). Indeed, there is a method of estimating the value of shadow
economy using mainly the monetary indicators called currency demand methods. This method
has many advantages and was applied by Tanzi (1982), up to now, there are several research
applied this method to estimate the value of shadow economy such as Schneider (1986),
Ahumada, Alvaredo, and Canavese (2007) , etc. Indeed, Bajada and Schneider (2005) claimed
that the currency approach is the benchmark of estimating shadow economy.

2.1.1.3.2. Labor Market Indicators
As discussed above, the shadow economy will shift the labors from official economy into
shadow economy. Therefore, to observe the changes in this area, there are 2 variables used in the
study of Schneider, Buehn, and Montenegro (2010):
1. The labor participation rate
2. Growth rate of total labor force
These 2 variables will help to discover the moving of labors to shadow economy indirectly.
2.1.1.3.3. State of the Official Economy
To see the effect of official economy on the development of shadow economy, some authors
used the GDP per capita variable (Schneider, 2011). This variable will provide the information
on the living standard of the nation as well as indicating the status of the economy (booming or
recession).
2.1.2. The review on financial development theories
The research about financial development usually related to economic growth.
Furthermore, financial development is an important input to the common goal of each country's
growth (De Gregorio & Guidotti, 1995). Therefore, to understand the financial development, an
initial understanding about economic growth is necessary. Indeed, definition of economic growth
as an integrated process that includes improvements in all areas of society and welfare of the
entire population maintained while minimizing extreme poverty and the economic deprivation of
any part of society. The concept of economic growth is defined as the growth rate of total
economic output, including the contribution of capital accumulation in this output (Khan, 2001).
Growth is still a necessary but not sufficient condition for economic growth. Among the most
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important inputs to economic growth are financial resources and access to these resources in all
spheres of economic activity (Levine, 1997). This explains the reason why the government should
care about the shadow economy because the main goal of the government is the economic growth
but to achieve the goal, they should facilitate the financial development and interestingly, the
financial development has mutual relationship with the shadow economy logically. Indeed, in the

research of Straub (2005) and Elgin & Uras (2013b) showed the negative effect of shadow
economy on the financial development. They argued that the government policies related to taxes
will increase the size of shadow economy and then increase in shadow economy will inhibit the
financial development. Actually, when the taxes are lower, it means that the costs of operating in
official economy is lower or the opportunity of operating in shadow economy is higher. Whereas
there are empirical evidence from research of Capasso & Jappelli (2013) stated that the financial
development will shrink the size of shadow economy.
The government should intervene in developing policy process of financial development to
reach the goal of economic growth. The role of financial institutions and their policies in
economic growth is addressed in Stiglitz and Stiglitz (2000), showing that the design of financial
institutions and policies plays an important role to the point of economic growth. Furthermore,
the changes in the policy which affect positively the financial development will be considered as
a shock created by financial development and will affect in shadow economy. On the other hand,
the shock created by shadow economy here in this research is considered as the causes which will
increase the size of the shadow economy such as the increase in taxation (because this study
focused on the shadow economy created by tax burden). The additional point is that when the
government has any actions which affect the financial development will somehow create a shock
on shadow economy and this section will be discussed in section 4: results and discussion
Obviously, financial markets are the intermediaries of the economy, contributing to capital
accumulation and technological innovation, and are closely linked to economic growth. The
theories emphasize that the development of the financial system is an important factor of the
economy in the long-term. The developed financial system can facilitate economic growth
through multiple channels. According to Drake (1980); Fritz (1984); Garcia and Liu (1999); Beck
and Levine (2005), these channels include:
(i)

Providing information on feasible investments, to effectively regulate the capital;

(ii)

Monitoring the corporates and corporate governance in public sector;
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(iii)

Diversification of risk;

(iv)

Mobilizing and aggregating savings;

(v)

Facilitating the exchange of goods and services; and technology transfer.

The financial sector serves many of the important functions of the economy, as countries
with low levels of financial development will deal with capital deficits, lack of competitiveness,
and financial injustice as well as limited ability to gather information for lenders, (Bose et al.,
2012). It is the fundamental for the development of shadow economy and therefore again it
appears to a relationship between the financial development and shadow economy.
When Love and Zicchino (2006) did a research about financial development for business
experience on financial constraints, which is a criterion for distinguishing between low levels of
financial development and high levels of financial development countries. The countries with
high developed financial system are places where firms are more experienced in the financial
constraints of the business as well as the financial market’s products. Thus, it will raise the
opportunity cost of operating in shadow economy.
2.1.2.1.

The origin of financial development

The concept of financial development is not new in literature. However, understanding the
concept clearly will help to measure and observe it precisely. This part will introduce the origin
of financial development and the determinants of financial development. Including institutions,
macroeconomic elements, geographic factors and others.
2.1.2.1.1. Institutions
Institutions are mentioned because it played an important role in creating the concept of
financial development. Obviously, the regulations affecting some major related variables such as
property rights, the enforcement of agreements, accounting standards, etc. which definitely affect
the financial development (Porta, Lopez-de-Silanes, Shleifer, & Vishny, 1998). According to
Beck and Levine (2005), a country with strong regulation in terms of efficiently enforcement of
agreements will have higher financial development. On the other hand, country with weak
enforcement of regulations will have lower financial development. Indeed, the disclosure of
information, accounting standards, operation of banking system regulation and financial
insurance are all defined in the regulations which have a strong effects on financial development
(Mayer & Sussman, 2001). A deeper analysis of this issue is the interest group and its influence
on the financial development, a recent study of political economy mentioned that the interest
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group may affect the regulations in order to maximize their benefits. Then, it obviously affects
the financial development (Pagano & Volpin, 2001). Additionally, the study of Rajan and
Zingales (2003) stated that the trade openness and financial openness are affected by the interest
groups who can interfere in the financial market and the financial development is only better with
both openness environment.
In short, institutions plays an important role on financial development. The financial
development will depend somehow on the development of institutions of that nation. However,
due to the limitation of time and data, this research did not take into account the institutions as a
variables in our model.
2.1.2.1.2. Policy

As discussed above, the institutions will affect the financial development through its
intervention. However, how they can intervene the financial development? Actually, the policy
is the key for the institutions to open the power of intervening the financial development. In fact,
macroeconomic policies can promote the openness of trade by maintaining the low inflation rate
which will encourage the capital inflow. As the trade is open, the financial development is
definitely improved. Indeed, the study of Huybens and Smith (1999) theoretically and Boyd,
Levine, and Smith (2001) claimed empirically that the nations with low inflation rate will have
more efficient banks and equity markets. Furthermore, the recent work of Do and Levchenko
(2009) also has the alignment with the view of policies which may encourage the openness to
trade and then the financial development. Moreover, Claessens (1998) in their study figured out
that the function of banking systems and the quality of financial market are improve with opening
banking systems. Claessens and Laeven (2003) found out that the opening banking systems may
help to reduce the costs of financial transactions and stimulate the financial development.
2.1.2.1.3. Geography
The concept of geography initially seem not relevant with financial development concept.
However, in some studies, researchers have pointed out the relationship between geography and
financial development. Indeed, in the research of Gallup, Sachs, and Mellinger (1999), they found
out that tropical climate countries which are near the equator will have poor production of crop
and then it will lead to institution issues. Moreover, the studies of Sachs, Warner, Åslund, and
Fischer (1995), Easterly and Levine (2003); Malik and Temple (2009) stated that the countries
with landlocked will have less chance to open their trade as well as the opportunity for building
up the comparative manufactured goods. Then, it will lead to less openness of trade and as a
result, the financial development will be counted on. The last area which researchers focuses on
is the resource endowment and economic development. In the study of Isham, Woolcock,
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Pritchett, and Busby (2005) the developing countries with rich natural resources will develop
their countries through just identical channel and it may put the countries in risky situations and
then it affects the economic development as well as the financial development as a result.

In short, geography does affect the financial development in terms of demand side of
financial development or the quality of institutions.
2.1.2.1.4. Other considered variables
There are still some other variables affecting the financial development which are economic
growth, the income, population, etc. Greenwood and Jovanovic (1990) and Saint-Paul (1992)
concluded that when a country has a strong economic growth, they will have costs advantages of
financial intermediaries. Indeed, when the economic grows, there are more money flow – in the
markets via financial channels (intermediaries) such as banks, it will reduce the costs of these
transactions. Additionally, this conclusion leads the author to the belief that there are the positive
relationship between financial development and shadow economy.
In addition, the relationship between income and financial development empirically tested
through the study of Levine (1997), Easterly and Levine (2003) and Beck and Levine (2005). The
research of Jaffee and Levonian (2001) also found out a specific evidence of the relationship in
banking development by using the data of bank assets, numbers, and employees. The result shows
the positive relationship between income and banking system development.
Last but not least, the financial development is also affected by the culture (especially
religion and language). In fact, culture helps to foresee the differences in the enforcement of
creditor rights as well as investor rights and from that it may affect the trade openness (Stulz &
Williamson, 2003). Furthermore, the study of Djankov, Glaeser, La Porta, Lopez-de-Silanes, and
Shleifer (2003) opened a new variable which may affect financial development is the state
ownership.

2.1.2.2.

General determinants of measuring financial development

A direct result from McKinnon and Shaw (1973) and Shaw (1973) showed that interest rate
regime, reserve requirements and credit programs were the main causes on the financial
development. Indeed, they found out the negative result when a country having high interest rate,
high required reserves and direct credit programs tends to have lower financial development level.

In the study, the problem of financial development is the allocation of credits. Obviously, if the
government interfered to the process of credit allocation, it would be likely a corruption because
the money will go to the “interest sectors”. Therefore, a policy which can eliminate the interest
rate ceilings, set the required reserve lower and liberate the financial systems form government
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