The nexus between the shadow economy and financial development in Uganda

Abstract

This paper examines the nexus between the shadow economy and financial development in Uganda making use of yearly time series data over the period 1991 to 2017 and autoregressive distributed lag (ARDL) method is applied. Findings are quite telling. We find that financial development reduces the shadow economy in a significant manner, in both the long- and short-run. This finding is robust to the use of alternative measures of financial development. Our results have far reaching implications. Firstly, findings indicate that financial structure plays a key role in mitigating the increase of the shadow economy given that the financial sector can provide access to credit that eases financial constraints faced by entrepreneurs. Thus, a well-functioning financial sector could facilitate access to credit by entrepreneurs which reduces their motivation to operate underground. These findings seem to suggest that reforming financial institutions to facilitate improved access to domestic credit could help tackle widespread informality in developing economies. Additionally, minimizing informality also requires reforming the political system, institutional framework and macroeconomic environment to become responsive to the needs of businesses.