Informality and financial development: A literature review

Abstract

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 non-monotonic and 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, suggests causality running in either direction.