DP17565 From Financial Development to Informality: A Causal Link
Financial development reduces the cost of accessing external financing and thus incentivizes investment in higher-productivity projects that allow firms to expand to the scale needed to operate in the formal economy. It also encourages participants of the informal sector to join the formal sector to gain access to credit and other financial services. This paper documents two findings. First, countries with less pervasive informality are associated with greater financial development. Second, the impact of financial development, and especially banking sector development, on informality is causal. This causal link is established using a novel instrumental variable for domestic financial development: financial development in other (neighboring) countries. The causal link between informality and financial development is stronger in countries with greater trade openness and capital account openness. The findings are robust to alternative specifications.