Shadow economy, financial inclusion and economic growth Nexus: evidence from developing countries

Abstract Shadow economy creates a significant barrier to economic progress in developing economies, whereas financial inclusion plays a crucial role in boosting economic performance. This study examines the impact of the shadow economy on economic growth and explores how financial inclusion moderates this relationship. We use two key dimensions of financial inclusion, including financial market development and financial institution development. We apply system GMM and difference GMM techniques on a dataset of 120 selected developing economies worldwide, from 2002 to 2020. The estimation results reveal that a sizeable shadow economy significantly hampers economic growth, while higher levels of financial inclusion improve it. Additionally, financial inclusion, particularly through the development of financial markets and institutions, moderates the adverse effects of the shadow economy on economic growth, suggesting a significant substitutability between the shadow economy and financial inclusion. This indicates that increasing financial inclusion reduces the size of the shadow economy and mitigates its harmful effects on economic growth. These results remain robust when using an alternative measure of the shadow economy. Based on the findings, we recommend governments promote financial inclusion initiatives, such as expanding banking services, advancing mobile banking, and increasing financial literacy.