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

Executive Summary

This report presents an empirical analysis of the relationship between the shadow economy, financial inclusion, and economic growth in 120 developing countries from 2002 to 2020. The findings indicate that a large shadow economy significantly impedes economic progress, directly undermining Sustainable Development Goal 8 (Decent Work and Economic Growth). Conversely, greater financial inclusion, measured through financial market and institutional development, is a potent driver of economic growth and a key enabler for achieving multiple SDGs. Critically, the analysis reveals that financial inclusion mitigates the adverse effects of the shadow economy. This suggests that policies aimed at expanding access to formal financial services can transition economic activity from the informal to the formal sector, thereby strengthening institutions (SDG 16), reducing inequalities (SDG 10), and fostering sustainable and inclusive growth (SDG 8). The results, derived from robust system GMM and difference GMM estimators, underscore the necessity of integrating financial inclusion strategies into national development plans to accelerate progress toward the 2030 Agenda for Sustainable Development.

1.0 Introduction: The Shadow Economy’s Challenge to Sustainable Development

1.1 Context and Problem Statement

The shadow economy, comprising economic activities outside formal regulatory and tax frameworks, poses a substantial barrier to sustainable development, particularly in developing nations. Its prevalence undermines progress on several Sustainable Development Goals (SDGs) by:

• Eroding the tax base, which limits public investment in critical infrastructure, education, and healthcare (Impacting SDG 3, SDG 4, SDG 9).
• Distorting economic indicators and complicating policy implementation, hindering effective governance (Impacting SDG 16: Peace, Justice, and Strong Institutions).
• Perpetuating precarious work conditions with no social protections, which obstructs the achievement of SDG 8: Decent Work and Economic Growth.

In contrast, financial inclusion is recognized as a critical enabler for achieving sustainable development. By providing access to formal financial services, it empowers individuals and businesses, reduces poverty (SDG 1), and promotes economic resilience. This study investigates whether enhancing financial inclusion can serve as a strategic policy lever to counteract the negative impacts of the shadow economy and steer developing economies toward a path of inclusive and sustainable growth.

1.2 Research Objectives and Hypotheses

The primary objective is to analyze the moderating role of financial inclusion in the relationship between the shadow economy and economic growth. The study tests the following null hypotheses:

1. The shadow economy has no relationship with economic growth in developing countries.
2. Financial inclusion has no relationship with economic growth in developing countries.
3. Financial inclusion does not moderate the negative impact of the shadow economy on economic growth in developing countries.

2.0 Methodology and Analytical Framework

2.1 Data and Scope

The analysis utilizes a balanced panel dataset covering 120 developing economies over the period from 2002 to 2020. The selection of countries and the timeframe was determined by data availability, allowing for a comprehensive cross-country examination.

2.2 Key Variables and their Relevance to SDGs

• Economic Growth (ECOG): Measured as the log difference of real GDP per capita. This is the primary indicator for tracking progress on SDG 8.
• Shadow Economy (SE): Measured using two robust proxies, the Multiple Indicators and Multiple Causes (MIMIC) model and the Dynamic General Equilibrium (DGE) model. A large SE is antithetical to the principles of decent work and formal employment in SDG 8 and strong institutions in SDG 16.
• Financial Inclusion (FINI): The moderating variable, measured through two dimensions:
  • Financial Market Development (FMD): Reflects the depth and efficiency of capital markets, crucial for financing innovation and infrastructure (SDG 9).
  • Financial Institution Development (FID): Captures the accessibility and stability of banking services, essential for poverty reduction and reducing inequality (SDG 1, SDG 10).
• Control Variables: Physical capital, human capital, industrialization, and inflation were included to ensure a comprehensive model of economic growth determinants, all of which are linked to various SDG targets.

2.3 Econometric Approach

To address potential endogeneity and dynamic bias inherent in growth models, this study employs advanced panel data techniques. The Generalized Method of Moments (GMM) estimator, in both its “difference GMM” and “system GMM” forms, was applied. This methodology ensures the credibility of the causal inferences drawn from the analysis.

3.0 Key Findings: Financial Inclusion as a Catalyst for SDG Achievement

3.1 The Detrimental Impact of the Shadow Economy on SDG 8

The estimation results confirm a statistically significant and negative relationship between the size of the shadow economy and economic growth. This finding supports the “sands the wheels” hypothesis, indicating that informal economic activities hamper overall economic performance. For every percentage point increase in the shadow economy, economic growth is adversely affected. This directly obstructs the achievement of SDG 8 by fostering inefficient resource allocation, reducing public revenues needed for development, and undermining formal labor markets.

3.2 The Positive Role of Financial Inclusion in Economic Growth

The analysis reveals that higher levels of financial inclusion, through both financial market development (FMD) and financial institution development (FID), are significantly associated with improved economic growth. This underscores the role of financial inclusion as a key accelerator for the 2030 Agenda. By facilitating savings, investment, and entrepreneurship, inclusive financial systems contribute directly to:

• SDG 8: Promoting sustained, inclusive, and sustainable economic growth.
• SDG 1: Providing pathways out of poverty through access to credit and savings.
• SDG 10: Reducing income inequalities by empowering marginalized populations.

3.3 Financial Inclusion’s Moderating Effect on the Shadow Economy

The most critical finding is the significant moderating role of financial inclusion. The interaction between the shadow economy and financial inclusion was found to be positive, indicating a substitutability effect. This means that as financial inclusion increases, the negative impact of the shadow economy on economic growth is diminished. Higher financial inclusion creates incentives for individuals and businesses to transition to the formal economy, thereby reducing the size and harm of the shadow sector. This mechanism is vital for building effective, accountable, and inclusive institutions as envisioned in SDG 16.

3.4 Robustness of Findings

The core findings remain consistent and robust when using an alternative measure for the shadow economy (the DGE model). This strengthens the validity of the conclusion that promoting financial inclusion is an effective strategy for mitigating the economic damage caused by informality.

4.0 Policy Implications for Accelerating the Sustainable Development Goals

The findings yield clear policy recommendations for governments and development partners aiming to achieve the SDGs.

4.1 Strengthening Institutions and Formalizing Economies (SDG 16 & SDG 8)

To curb the shadow economy, policymakers should prioritize initiatives that strengthen financial systems. This includes simplifying regulatory procedures and enhancing transparency to make formal economic participation more attractive. Such efforts contribute to building stronger institutions (SDG 16) and promoting formal employment (SDG 8).

4.2 Leveraging Financial Inclusion for Inclusive Growth (SDG 1, SDG 8, SDG 10)

Governments should actively promote financial inclusion as a central pillar of their national development strategies. Key actions include:

• Expanding the reach of traditional banking services to underserved areas.
• Advancing digital financial services, such as mobile banking, to lower transaction costs and improve access.
• Increasing financial literacy to ensure that individuals and small enterprises can effectively utilize financial products.

These measures will help reduce poverty (SDG 1), lessen inequalities (SDG 10), and drive inclusive economic growth (SDG 8).

4.3 Fostering Partnerships for Sustainable Development (SDG 17)

Achieving widespread financial inclusion requires a multi-stakeholder approach, aligning with SDG 17 (Partnerships for the Goals). Collaboration between governments, central banks, private financial institutions, and international organizations is essential to build an inclusive financial infrastructure that supports the formalization of the economy and advances the broader sustainable development agenda.

5.0 Conclusion and Future Directions

5.1 Summary of Contributions

This report provides robust empirical evidence that the shadow economy is a significant impediment to achieving SDG 8 in developing countries. More importantly, it demonstrates that financial inclusion is not only a driver of growth but also a powerful tool to mitigate the negative consequences of economic informality. By fostering a transition to the formal economy, financial inclusion helps build stronger institutions (SDG 16) and creates a more equitable society (SDG 10). The findings strongly advocate for placing financial inclusion at the heart of strategies aimed at sustainable and inclusive development.

5.2 Limitations and Avenues for Future Research

While this study provides valuable insights, it is subject to limitations, including data availability post-2020 and the inherent challenges of measuring the shadow economy. Future research could enhance this analysis by:

• Investigating the impact of specific types of financial inclusion, such as digital finance or microfinance, on informality.
• Conducting regional or country-specific case studies to capture the socio-economic nuances driving the shadow economy.
• Exploring the role of other institutional factors, such as political risk and economic policy uncertainty, in shaping the relationship between informality, financial inclusion, and the SDGs.

Analysis of Sustainable Development Goals in the Article

1. Which SDGs are addressed or connected to the issues highlighted in the article?

The article on the shadow economy, financial inclusion, and economic growth in developing countries is directly and indirectly connected to several Sustainable Development Goals (SDGs). The core themes of promoting economic progress, formalizing the economy, and expanding access to financial services align with the following SDGs:

• SDG 8: Decent Work and Economic Growth: This is the most central SDG to the article. The entire study revolves around understanding the barriers to and drivers of “economic growth (ECOG)” in developing economies. It directly addresses the negative impact of the “shadow economy (SE)” on growth and employment, and explores policies to foster a more robust and formal economy.
• SDG 9: Industry, Innovation, and Infrastructure: The article acknowledges the role of industrialization and capital investment in economic performance. It includes “industrialization (IND)” and “physical capital (Phy.Cap)” as key variables influencing economic growth. Furthermore, financial inclusion is presented as a mechanism that encourages “entrepreneurship and innovation.”
• SDG 10: Reduced Inequalities: Financial inclusion is a key theme, which is fundamentally about reducing inequalities in access to economic resources. The article advocates for expanding financial services to “underserved populations,” which helps bridge the gap between those in the formal and informal sectors and provides economic opportunities for the most vulnerable.
• SDG 16: Peace, Justice, and Strong Institutions: The article links the existence of a large shadow economy to institutional failures. It states that the shadow economy is attributed to “weak institutions, corruption, and ineffective governance.” The proposed solution of strengthening financial systems through “better regulations and stronger monitoring” directly relates to building effective, accountable, and transparent institutions.

2. What specific targets under those SDGs can be identified based on the article’s content?

Based on the detailed discussion in the article, several specific SDG targets can be identified:

1. SDG 8: Decent Work and Economic Growth

   • Target 8.1: Sustain per capita economic growth. The article’s primary dependent variable is “Economic Growth (ECOG),” measured as the “log difference of real per capita GDP.” The entire study is dedicated to identifying factors that hamper or promote this target in 120 developing economies.
   • Target 8.3: Promote development-oriented policies that support… formalization and growth of micro-, small- and medium-sized enterprises, including through access to financial services. This target is at the heart of the article’s argument. The study investigates how “financial inclusion (FINI)” can “aid the transition from informal to formal sector” and mitigate the negative effects of the shadow economy. It highlights that access to “formal financial services, including banking, credit, and insurance” is crucial for this transition.
   • Target 8.10: Strengthen the capacity of domestic financial institutions to encourage and expand access to banking, insurance and financial services for all. The article explicitly recommends that governments “promote financial inclusion initiatives, such as expanding banking services, advancing mobile banking, and increasing financial literacy.” It uses “financial institution development (FID)” as a key indicator, directly aligning with this target.

2. SDG 9: Industry, Innovation, and Infrastructure

   • Target 9.2: Promote inclusive and sustainable industrialization. The study includes “Industrialization (IND)” as a control variable, acknowledging its role as a key driver for transforming economies and improving “productivity and ECOG.”
   • Target 9.3: Increase the access of small-scale industrial and other enterprises… to financial services, including affordable credit. The article’s focus on financial inclusion directly supports this target. It argues that FINI stimulates economic growth by “making lending to businesses easier” and “mobilizing savings,” which are essential for small enterprises, particularly those looking to transition from the informal to the formal sector.

3. SDG 16: Peace, Justice, and Strong Institutions

   • Target 16.6: Develop effective, accountable and transparent institutions at all levels. The article implicitly addresses this target by identifying “weak institutions, corruption, and ineffective governance” as root causes of the shadow economy. The promotion of financial inclusion is presented as a way to enhance transparency and accountability, as “FINI ensures more people have access to formal financial services, making legal transactions more attractive and less challenging to avoid.”

3. Are there any indicators mentioned or implied in the article that can be used to measure progress towards the identified targets?

Yes, the article mentions and uses several quantitative variables that serve as direct or proxy indicators for measuring progress towards the identified SDG targets.

• Indicator for Target 8.1: The article’s primary outcome variable, Economic Growth (ECOG), is measured as the “log difference of real per capita GDP multiplied by 100.” This is a direct proxy for the official SDG indicator 8.1.1 (Annual growth rate of real GDP per capita).
• Indicator for Target 8.3: The article uses the size of the Shadow Economy (SE) as a percentage of GDP, measured via the MIMIC and DGE models. While SDG indicator 8.3.1 measures the “proportion of informal employment,” measuring the overall size of the informal economy is a crucial and directly related metric for tracking progress on formalization.
• Indicator for Target 8.10: The study uses a composite measure for Financial Inclusion (FINI), which is broken down into two indices: the Financial Market Development (FMD) index and the Financial Institution Development (FID) index. These indices, which capture the depth, access, and efficiency of financial systems, serve as comprehensive indicators for measuring access to banking and financial services, aligning with SDG indicator 8.10.2 (Proportion of adults with an account at a bank or financial institution). The article’s recommendation to advance “mobile banking” also points towards this indicator.
• Indicator for Target 9.2: The variable Industrialization (IND) is measured as the “value added in industry, including construction, as % of GDP.” This aligns closely with SDG indicator 9.2.1 (Manufacturing value added as a proportion of GDP and per capita).
• Indicator for Target 9.3: The indicators for Financial Inclusion (FMD and FID indices) also serve as measures for this target, as they quantify the development of financial systems that provide “access to credit” for businesses.

4. Summary Table of SDGs, Targets, and Indicators

Source: nature.com