The mutual effects of shadow economy and financial development in asean countries

When we analyzed the relationship between shadow economy and financial development, we found out that in the study of Straub 2005:  Increases in shadow economy decreases in financial d

VIETNAM - THE NETHERLANDS PROGRAMME FOR M.A

IN DEVELOPMENT ECONOMICS

THE MUTUAL EFFECTS OF SHADOW ECONOMY AND

FINANCIAL DEVELOPMENT IN ASEAN COUNTRIES

by Nguyen Hoang Phu

A thesis submitted in partial fulfilment of the requirements for

the degree of

Master of Art in Development Economics

Ho Chi Minh city, January 2018

VIETNAM - THE NETHERLANDS PROGRAMME FOR M.A IN

DEVELOPMENT ECONOMICS

THE MUTUAL EFFECTS OF SHADOW ECONOMY AND

FINANCIAL DEVELOPMENT IN ASEAN COUNTRIES

by Nguyen Hoang Phu

A thesis submitted in partial fulfilment of the requirements for

the degree of

Master of Art in Development Economics

Academic Supervisor:

Dr Pham Thi Thu Tra

Ho Chi Minh city, January 2018

DECLARATION

I hereby declare that my dissertation entitled “THE MUTUAL EFFECTS OF SHADOW ECONOMY AND FINANCIAL DEVELOPMENT IN ASEAN COUNTRIES” is the result of my own work and includes nothing which is the outcome

of work done in collaboration except as declared in the Preface and specified in the text

I also confirm that:

 This thesis was done wholly while in candidature for a research degree at VNP;

 Where any part of this thesis has previously been submitted for a degree or any other qualification at VNP or any other institution, this has been clearly stated;

 Where I have consulted the published work of others, this is always clearly attributed;

 Where I have quoted from the work of others, the source is always given

 With the exception of such quotations, this thesis is entirely my own work, and I have acknowledged all main sources of help

Date: January 02, 2018 Signature

Full name: Nguyen Hoang Phu

ACKNOWLEDGEMENT

This thesis cannot complete without the support of my supervisor, Dr Pham Thi Thu Tra, who has spent the value time, efforts, and energy to guide me on the thesis during the time of completing the thesis Her dedication made me motivated when I have a chance to discuss with her, her expertise is what makes me impressive when I ask her questions about my thesis’s topic, and she also kept me in the “can – do” attitude when I faced any difficulties in doing thesis All of these leave me with the most unforgettable memory and experience My purpose of this acknowledgement is to express my gratitude to my supervisor Without her supports, I may not have a chance

to pursue my dream

I would like to send my special thanks to Prof Nguyen Trong Hoai, Dr Pham Khanh Nam, Dr Truong Dang Thuy for their valuable command, guidance and support during the program Without your support and encouragement, I may not complete the thesis as expected

Additionally, my thanks are given to all of the lectures who have been my knowledge guiders and the staff who have been my service supporters throughout the master program at University of Economics and Erasmus University Rotterdam Without their help, never can I have an opportunity to proceed and complete my master thesis

Last but not least, I would like to thank Mr Nguyen Cong Thanh, Truong Thi Thu May and my family who have always been a pillar for me to rely on during the hardships

of attempting to achieve the master thesis It is their unspoken sacrifice and untiring work that bring me more spare time to be able to reach the final destination of my progress

ABSTRACT

This study focuses on examining the mutual relationship between financial development and shadow economy by applying the theoretical and empirical framework Our research contributed to the way of calculating the size of shadow economy applied the currency demand approach with updated data from 1997 to 2015 for 8 ASIAN countries In particular, to have a robust result, we used 4 estimation methods including POLS, FEM, REM and SGMM to calculate the value of the size of shadow economy of each country Then, we took each received results to examine the mutual effect with the financial development using P – VAR approach We found that when the positive shock caused by the financial sector affects the shadow economy, the shadow economy will immediately respond negatively to the shock On the other hand, when a positive shock caused by credit for private sector will lead to the positive responses of the shadow economy Interestingly, in this case, the response tends to last longer with the estimated results from static model of shadow economy in comparison with dynamic model of shadow economy

Keywords: Shadow economy, financial development

JEL classifications: G32, H26

TABLE OF CONTENTS

Chapter 1: Introduction 11

1.1 Problem statements 11

1.2 Research objectives 13

1.3 Scope of the study 14

1.4 Structure of the thesis 15

Chapter 2: Literature review 16

2.1 Review of theory 16

2.1.1 The theory of shadow economy 16

2.1.2 The review on financial development theories 21

2.2 Review of empirical studies on the relationship between financial development theory and shadow economy theory 27

2.3 Summary 31

Chapter 3: Research methodology 34

3.1 Analytical framework 34

3.2 Econometric models 36

3.3 Data 40

3.4 Variables and sampling 40

Chapter 4: Research results 42

4.1 Overview of the research topic 42

4.2 Descriptive statistics 44

4.3 Regression results and discussions 45

Chapter 5: Conclusions 55

5.1 Conclusions 55

5.2 Limits of the study 56

Reference 58

Appendices 65

LIST OF TABLES

Table 1: Descriptive Statistics for the whole dataset 44

Table 2: Matrix of correlation coefficients 44

Table 3: Estimated results of currency demand model 46

Table 4: Optimal model selection tests 47

Table 5: Estimated value of Shadow economy over GDP 48

Table 6: The results of Unit Root Test 49

LIST OF CHARTS

Figure 1: Conceptual framework of shadow economy and financial development 31 Figure 2: The technical structure to deal with data 34 Figure 3: The analyzed results of impulse response function when the size of shadow

economic creates a shock with the estimated value of shadow economy from the static models (POLS, FEM, REM) 51 Figure 4: The analyzed results of impulse response function when the size of shadow

economic creates a shock with the estimated value of shadow economy from the dynamic models (SGMM) 52 Figure 5: The analyzed results of impulse response function when the financial development

creates a shock with the estimated value of shadow economy from the static models (PLOS, FEM, REM) 53 Figure 6: The analyzed results of impulse response function when the financial development

creates a shock with the estimated value of shadow economy from the dynamic models (SGMM)) 54

LIST OF APPENDICES

Appendix 1: Shadow economy estimation using POLS 65

Appendix 2: Shadow economy estimation using FEM 65

Appendix 3: Shadow economy estimation using SGMM 66

Appendix 4: Shadow economy estimation using REM 67

Appendix 5: Hausman Test 67

Appendix 6: Breusch & Pagan Lagrangian multiplier test for random effects 68

Appendix 7: Stationary test for shadow size estimated by POLS 68

Appendix 8: Stationary test for first difference of shadow size estimated by POLS 69

Appendix 9: Stationary test for shadow size estimated by FEM 69

Appendix 10: Stationary test for first difference of shadow size estimated by FEM 70

Appendix 11: Stationary test for shadow size estimated by REM 71

Appendix 12: Stationary test for first difference of shadow size estimated by REM 71

Appendix 13: Stationary test for shadow size estimated by SGMM 72

Appendix 14: Stationary test for first difference of shadow size estimated by SGMM 72

Appendix 15: Stationary test for financial development measured by Credit for private sectors 73

Appendix 16: Stationary test for first difference of financial development measured by Credit for private sectors 73

Appendix 17: Stationary test for financial development measured by Credit from financial sectors 74

Appendix 18: Stationary test for first difference of financial development measured by Credit from financial sectors 74

Appendix 19: Stationary test for money supply ratio 75

Appendix 20: Stationary test for first difference of money supply ratio 75

Appendix 21: Stationary test for natural logarithm of GDP per capita 76

Appendix 22: Stationary test for first difference of natural logarithm of GDP per capita 76

ABBREVIATIONS

POLS: Pooled Ordinary Least Squared

FEM: Fixed Effects Model

REM: Random Effects Model

of a nation to know about shadow economy’s activities and then they could make the economy more efficient in terms of allocating resources However, getting precise information about shadow economy’s activities is hard, even with goods and labor working in the economy because people tend to hide their activities’ in the market Therefore, doing the research in this area requires passion of the scientists and willing to explore “the unknown” This is the first motivation

of author to research about this area

Additionally, shadow economy is one of the main reasons that make the government revenue for public goods reduce Indeed, there are 75% of productions in developing countries taken place underground while it is about 10% in developed countries (Enste & Schneider, 2000) Entering the shadow economy, it means that the businesses and institutions can be out of the control of the government and it called “fly under the radar” by Enste and Schneider (2000) Thus, the shadow economy will undermine the ability of the government in building up the foundations

as well as the capacity of governments to collect the taxes (government’s income) for public goods and other trading promotion programs (Enste & Schneider, 2000; Gërxhani, 2004) As a result, the study about the shadow economy will touch many other areas and it will lead to a broad research (Enste & Schneider, 2000; Gërxhani, 2004; Johnson, Kaufmann, & Shleifer, 1997; Schneider, 2005, 2011; Tanzi, 1982) An intensive comprehension of the determinants of “secret action” will help law - makers and governors in creating powerful strategies which can fight back the uncontrollable exercises and encourage economic growth Thus, this is the second motivation for the author to study about this area

To dig deeper in the field of this research, Enste and Schneider (2000); Gërxhani (2004); Schneider (2005) stated that many other conducted studies found out that the difficulties in accessing the credits, loans and the opportunity costs of these procedures are the main determinants of shadow economy (Enste & Schneider, 2000; Gërxhani, 2004; Schneider, 2005) Indeed, a country with strict assessments to have a loan or there are many barriers to open a new

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business will form a kind of foundations which is the origin of the initial shadow development (Dreher, Kotsogiannis, & McCorriston, 2007; Friedman, Johnson, Kaufmann, & Zoido-Lobaton, 2000; Johnson et al., 1997; Teobaldelli, 2011; Torgler & Schneider, 2009) These organizations (like commercial banks, financial institutions, insurance company, etc.) who will provide the securities which can help the businesses to access the credit but they usually require the collateral contract and in the case that a start – up business does not have assets, they have to deal with the lack of credits and capital to operate their business in the early stage As a result, they will seek a new way to access the credit with lowest opportunity costs and it is the time for the development

of shadow economy Furthermore, in the study of Vũ Việt Quảng and Lê Thị Phương Vy (2016), they also showed that the ability of accessing to credit will contribute to the success of a business and therefore this ability may affect the choice of a business to operate in the official economy or shadow economy The research of Nguyễn Thị Thùy Linh, Trần Huy Hoàng, and Nguyễn Hữu Huân (2015) about the financial liberalization and the economic growth stated that the financial development is the factor that fosters the financial liberalization and then economic growth, as a result, it revealed that taking economic growth variable in the study should be considered

As a result, the money related area is one specific kind of establishment that is probably going to influence the spread of the shadow economy (Blackburn, Bose, & Capasso, 2012; Bose, Capasso, & Andreas Wurm, 2012; Capasso & Jappelli, 2013; Dabla-Norris, Gradstein, & Inchauste, 2008; Straub, 2005) In particular, the financial sectors serves numerous critical capacities in an economy by giving business visionaries access to required credit, and allows observing business exchanges for assessable purposes Subsequently, money related improvement raises the open-door cost of creating in the shadow economy by bringing down the boundaries to acquiring credit, and along these lines, gives a motivation to casual business people

to move towards authenticity (Blackburn et al., 2012; Capasso & Jappelli, 2013) Moreover, to the degree that the legislature can utilize the budgetary area to effectively screen and duty exchanges, the advancement of the monetary segment brings down the events of assessment avoidance, and accordingly, assist mitigates the spread of the shadow economy (Blackburn et al., 2012; Capasso & Jappelli, 2013)

Recent researches about the topic done by Enste and Schneider (2000), and Schneider and Enste (2013); Feld and Schneider (2010) are still controversial due to the disagreement of the definition of shadow economy and the procedure of estimating as well as the uses of the estimates

in economic and policy analysis In South East Asia, there were some researches on measuring the size of shadow economies such as the study of Võ Hồng Đức, Lý Hưng Thịnh, and Tống Thị Hồng Nhung (2015) researched on the field of shadow economy and also connected the concept

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of shadow economy with other factors such as the unemployment rate and economic growth which is the motivation for the author to see another connection of shadow economy with other factors Indeed, in this research, the considered factor is the financial development which is closely related to the economic growth (De Gregorio & Guidotti, 1995) However, the number of researches on how shadow economy effects on other elements of the economy is still quite limited and scarce Thus, this thesis attempts to fulfil this gap by using updated data of 8 ASIAN countries and self – estimating the value of shadow economy for each countries Moreover, this research will apply the same estimation technique with the research of Ardizzi, Petraglia, Piacenza, and Turati (2014) and Enste and Schneider (2000) to estimate the value of shadow economy Then,

we will apply various models such as POLS, FEM, REM and SGMM to test the relationship of shadow economy and financial development to ensure the robustness of the results

When we analyzed the relationship between shadow economy and financial development,

we found out that in the study of Straub (2005):

 Increases in shadow economy decreases in financial development and economic growth

On the other hand, the study of Capasso and Jappelli (2013) they claimed that:

 Increases in financial development  increases opportunity cost of producing in shadow economy  easier for Government to tax  decrease the shadow

economy

Our study will focus on these issues:

 By applying the currency demand method, we will see how many percentage of shadow economy over the total GDP of the overall researched countries?

 What is the effect of the shock created by shadow economy on the financial development and vice versa?

 Does the shadow economy have larger effect on financial development?

1.2 Research objectives

Our research objective is quite simple

1 First, we will see the size of shadow economy over the total GDP in each research country

2 Then, we examine the relationship between the shadow economy and financial development by observing the shock created by shadow economy on the financial development and the shock created by financial development on the shadow economy

We see that

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2.1.Increases in financial development  increases opportunity cost of producing in shadow economy easier for Government to tax decrease the shadow economy

2.2.Increases in shadow economy decreases in financial development and economic growth

Thus, we will examine the relationship based in the shock created by shadow economy and financial development on each other

Indeed, the shock created by shadow economy here in this research is considered as the causes which will increase the size of the shadow economy such as the increase in taxation (because this study focused on the shadow economy created by tax burden)

Moreover, the shock created by financial development in this research is considered as the causes which will increase the financial development such as the increase in credit supply

We do see the endogeneity in our model, but we will deal with it by using panel Vector auto regression

1.3 Scope of the study

This study focuses on the two main concepts which are shadow economy and the financial development Therefore, we will analyze each concepts separately Then we will conduct a review

on the empirical works of the two concepts

Firstly, the concept of shadow economy will be covered from the definition to the indicators

of shadow economy and in this research, we will observe the shadow economy through the angel

of tax burden mainly Therefore, we will apply currency demand approach to estimate the size of shadow economy Then, the financial development concept is also developed in the same way There is a discussion on the origin of financial development and how to measure the financial development After all of these discussions, the study will review some previous studies which connect the two concepts

For the employed model in the study, we followed the model of Tanzi (1983) to measure the size of shadow economy for 8 – ASEAN countries We also use the latest data for this study (from 1997 to 2015) We choose 8 – ASEAN countries because in the study of Carter (1984), Johnson, Kaufmann, and Zoido-Lobaton (1998) , Berdiev and Saunoris (2016) , they found out that there are a huge difference in the size of shadow economy in developed and developing countries Additionally, the countries in the same region tend to have similar tax burdens and the behavior of the regulation enforcement toward the shadow economy The limitation in collecting data is also the constraint when we choose 8 countries to study

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Finally, to test the relationship between the two concepts, we use P – VAR method to see whether the effect of shadow economy on financial development is negative or positive and vice versa

1.4 Structure of the thesis

In chapter 1, we have a brief introduction about the topic shadow economy and financial development The importance of study in this field is discussed and the objectives of this research

is also mentions Furthermore, to have a deep understand about the definition of shadow economy and financial development, chapter 2 will have a very detailed discussion on these two concepts The authors reviewed all the relevant theories as well as the empirical works in chapter 2 After the review on theories and empirical works, we come up with the methodology which we will apply for this study in chapter 3 Moreover, chapter 3 will discuss about the analytical framework and the econometric model which are used in our research Data collection is also mentioned in chapter 3 The results of this study is in chapter 4 which will show the regression results and the discussion of the author Finally, after receiving the research results, the author will come up with some conclusions and also suggest the policy implications based on the author’s points of view

in chapter 5 Furthermore, the limitation of this research is also discussed in this chapter

The detail of each chapter is below:

 Chapter 1: Introduction

 Chapter 2: Literature review

 Chapter 3: Research methodology

 Chapter 4: Research results

 Chapter 5: Conclusions and policy implications

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Chapter 2: Literature review

This chapter will go through the review of all related theories of shadow economy and financial development Then, there is a review of empirical works regarding to the relationship between 2 concepts: shadow economy and financial development Finally, summary section will provide an overview about the previous studies related to this field

2.1 Review of theory

This part will go through the concept of shadow economy and other theories related to shadow economy which will help to see the main determinants of the shadow economy Furthermore, it also will have a little discussion about the causes of shadow economy in order to have full understand of how shadow economy arises After that a review on financial development theories will be conducted to ensure the understanding of the origin of financial development concept Then, the determinants of financial development will be discussed

2.1.1 The theory of shadow economy

The shadow economy is the general concepts which are to reflect economic activities in an area that is contrary to the formal sector and is very important in the national economy Additionally, the definition of EU about shadow economy is that the economic activities that are not recorded on statistical and quantitative network; furthermore, OECD states that activities producing goods and services legally without declaring or producing unrelated goods and services and intangible income are activities of shadow economy

There are many studies on the existence of shadow economies such as Carter (1984), Johnson, Kaufmann, and Zoido-Lobaton (1998) , Berdiev and Saunoris (2016) and many others These studies can be divided into two main groups: studies of shadow economics in developed countries and studies in developing and underdeveloped countries The fundamental difference

in approach of these two groups comes from the different chatter of underground activities For developed countries, the shadow economy is seen as an overlooked part of the national economy

As for the developing and underdeveloped, the region is seen as an indispensable and integral part of the national economy This is also the reason why authors choose developing countries for analysis in order to avoid mistakes about the nature of shadow economy in different levels of national development

According to Schneider (2011), the negative impacts of the shadow economy on the economy are: tax-free, affecting government revenues, not counting on GDP, affecting statistics,

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additionally, it may be the place where the illegal activities occur that affect the economy, culture and society of the country and are not controlled by the state In addition, the shadow economy does not provide sufficient and accurate information for the proper planning of macroeconomic policies, the effectiveness of policies, the effectiveness of state management, and the effectiveness of the law are dismissed and disabled (Scott Hacker & Hatemi-J, 2008) Furthermore, the shadow economy also makes businesses and their products less competitive at the national level, and it is difficult to integrate into international trade to take advantage of the opportunities offered by the associations and easily out of the international economic movement, and become the periphery of development cooperation (Teobaldelli, 2011; Torgler & Schneider, 2009) Such an economy may push the nation backward in comparison with other nations or even the region The shadow economy also creates an unequal, untrustworthy and unfavorable business environment for honest businessmen who are detrimental to the formal sector Moreover, it creates unstable factors which may risk the investment decision The shadow economy also discourages and promotes creativity, discourages long-term investment, large-scale investments

or human resources development The shadow economy also limits the opportunities and the scale

of business due to the fact of the contributed capital mainly based on family relations, relatives, and inability to promote the advantages of scale (Schneider, 2005) In particular, it may create great public servants harassing, bribe and abuse power to serve the interests of individuals Obviously, the people working in the shadow economy do not have full social security coverage (J P Choi & Thum, 2005) The shadow economy, however, is also the place where many informal jobs are created, helping them earn a living and help the country survive a recession

About the causes and effects of the development of the shadow economy, there have been many discussions and studies, including Gërxhani (2004); Johnson et al (1997); Schneider (2005, 2011); Schneider and Enste (2000); Tanzi (1982) These research papers suggest that the severity

of administrative procedures and taxation are the main causes of the development of the shadow market, according to Gërxhani (2004); Johnson et al (1997); Schneider (2005, 2011); Schneider and Enste (2000) Furthermore, the shadow economy is also permitting individuals and companies to operate under the "fly under the radar" observation of state agencies due to internal weakness and weak management capacity of governments to provide mechanisms for transparency of goods and services (Schneider & Enste, 2000)(Gërxhani, 2004)

Studies of Dreher, Kotsogiannis, and McCorriston (2009); Friedman et al (2000); Johnson

et al (1998); Teobaldelli (2011); Torgler and Schneider (2009) found that in high taxed and strict

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policies countries increased the sensitivity of informal sector operations Some state administrative organizations take advantage of the high tariffs and the huge administrative burdens that underlie the development of shadow economy

In this study, the observations of shadow economy will be based mainly on the tax burdens Furthermore, in the study of Straub (2005) also stated that the barriers to access to public credit will promote the increase of shadow economy On the other hand, the support policies which reduce the tax burdens will shrink the size of shadow economy According to Elgin & Uras (2013b), the increase (decrease) of shadow economy will lead to the decrease (increase) of financial development The opposite view of Capasso & Jappelli (2013) claimed that the increase

in financial development will lead to the smaller size of shadow economy These two main theoretical frame works will be discussed further in the section 2.2

2.1.1.1 Defining the Shadow Economy

Initially, it is difficult to define shadow economy concept until 1997, Smith (1997) offered

a new definition of shadow economy He said that shadow economy was a kind of market – based production of goods and services not in the estimation of official GDP regardless its legitimation (legal or illegal) A broader definition is that all economic activities avoiding regulation and taxation considered as shadow economy activities

In this research, I follow the definition of shadow economy including all market – based legal activities which are intentionally concealed by public departments or authorized institutions due to any of these below reasons:

1 The payment of income and other taxes is evaded

2 The payment of social insurances benefits is evaded

3 To avoid committing labor legislation like minimum wages law, safety standards, benefits for maternity, etc

4 To not go through the complicated administrative procedures

The concept of shadow economy in this research does not cope with illegal activities which

is also considered as shadow economy activities such as burglary, drug dealing, etc Thus, these points above are our very first assumptions about the shadow economy concept In this research,

we just focused on the shadow economy created by the tax burdens Thus, the currency demand approach is the ideal choice for us to estimate the size of shadow economy (Epaphra, M., & Jilenga, M T., 2017)

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2.1.1.2 What causes the Shadow Economy?

2.1.1.2.1 Tax and other social products burdens

The first cause of shadow economy is tax and social insurance burdens which are also the concern of economists around the globe Indeed, taxes will affect the income of the labors incrementally and the social insurance will take out some proportion from the income of labor Thus, the larger gap between gross income (before taxes and expenses) and net income (after taxes and expenses), the higher portion of the development of shadow economy Due to this effect, taxes and social insurance burdens should be taken into account when measuring the size

of shadow economy

To prove the effect of tax on shadow economy, there are many studies on that such as of Del’Anno and Schneider (2005); Enste and Schneider (2000); Schneider (1994) and Friedman et

al (2000); Johnson et al (1998) All of these studies empirically provided evidences of the effect

of taxes (direct and indirect) on shadow economy Furthermore, these studies also found evidence

of the effect of social insurance burdens on shadow economy

Due to the complexity of taxation system across countries, the study of Buehn and Schneider (2009) suggested a comparable proxies for tax and social insurance burdens In details, the proxy was constructed by these variables:

1 The proportion of direct taxes on total taxes

2 Size of government: this variable will be built based on government expenditures

3 Fiscal freedom: the data from Heritage Foundation's economic freedom index

2.1.1.2.2 The level of regulations enforcement

The second cause of shadow economy is the rigidity of government regulations If the government manages economic strictly and then creates the barriers for business operations, it will discourage the engagement of business in the official economy Indeed, the “regulations” comprises the labor laws such as minimum wages law or the protection of labors regulations, etc., the trade regulations such as quotas or tariffs The empirical work of Johnson et al (1998) found out the effect of the regulations, especially the labor ones on the development of shadow economy Actually, if the government tightens the labor regulations, the labor costs will increase and then it is the opportunity for the development of shadow economy because all the costs would

be shifted to the workers Furthermore, this result also implies that the use of regulations or the enforcement is the key elements for driving firms and also labor to shadow economy In 2000, Friedman et al (2000) in their research, had the same result which stated that the relationship between regulations and shadow economy was obviously positive The research of Friedman et

al (2000) also recommended that the government should improve the enforcement of regulations

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2.1.1.2.3 Public services

The government income will decrease due to the development of shadow economy which affects negatively on the quality of public goods and services Thus, to maintain the quality of public goods and services, the government will tend to raise their income by increasing the taxes imposing on the institutions and businesses in the official sector These actions of the government will push the business toward the shadow economy The results from research of Johnson et al (1998) indicated that the country with lower tax rate and higher tax revenue, less regulations and corruptions will have shadow economy with smaller size Moreover, the nations with strong law system respected by their citizens will have a smaller size of shadow economy On the other hand, especially transition nations are likely to have higher size of shadow economies because they tend

to have higher taxes (rates and revenue) on official sectors In that research, they reached the conclusion that a country with lower tax rate, having strong financial fundamentals and low regulation burdens as well as good control of corruptions will have relatively smaller shadow economy than others with counter – conditions

2.1.1.2.4 Official economy

It is quite irony that official economy – itself is one of the reasons causing the shadow economy In various studies of Bajada and Schneider (2005); Schneider and Enste (2013); Feld and Schneider (2010), the official economy will affect the choice of working or not working in shadow economy of people and institutions Indeed, when the economy is in the expansionary state, the official economy will help to raise the opportunity costs of working in shadow economy

by providing good working conditions and facilitating the access to credits However, when the economy is in the recession state, the official economy will make the opportunity costs of operating in shadow economy lower and thus it encourage people to move to shadow economy

In order to observe these events, these below variables will be taken into account:

1 GDP per capita

2 Unemployment rate

These variables were used in the research of Feld and Schneider (2010)

2.1.1.3 What identifies the Shadow Economy?

It is hard to measure the shadow economy directly Thus, in order to measure the shadow economy, the author has to calculate it indirectly by using the various indicators In fact, there are

3 kinds of indicators which can be used to calculate shadow economy such as monetary indicators, labor market indicators and the official economy indicators

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2.1.1.3.1 Monetary Indicators

The medium of exchange in shadow economy is mainly in cash, all the transactions in shadow economy have to be in cash in order to make sure that they are out of the control of “the radar” and hence people cannot impose taxes on them Therefore, the variable M2 should be considered to use and the taxation variable T should be taken into account also (Ahumada, Alvaredo, & Canavese, 2008) Indeed, there is a method of estimating the value of shadow economy using mainly the monetary indicators called currency demand methods This method has many advantages and was applied by Tanzi (1982), up to now, there are several research applied this method to estimate the value of shadow economy such as Schneider (1986), Ahumada, Alvaredo, and Canavese (2007) , etc Indeed, Bajada and Schneider (2005) claimed that the currency approach is the benchmark of estimating shadow economy

2.1.1.3.2 Labor Market Indicators

As discussed above, the shadow economy will shift the labors from official economy into shadow economy Therefore, to observe the changes in this area, there are 2 variables used in the study of Schneider, Buehn, and Montenegro (2010):

1 The labor participation rate

2 Growth rate of total labor force

These 2 variables will help to discover the moving of labors to shadow economy indirectly 2.1.1.3.3 State of the Official Economy

To see the effect of official economy on the development of shadow economy, some authors used the GDP per capita variable (Schneider, 2011) This variable will provide the information

on the living standard of the nation as well as indicating the status of the economy (booming or recession)

2.1.2 The review on financial development theories

The research about financial development usually related to economic growth Furthermore, financial development is an important input to the common goal of each country's growth (De Gregorio & Guidotti, 1995) Therefore, to understand the financial development, an initial understanding about economic growth is necessary Indeed, definition of economic growth

as an integrated process that includes improvements in all areas of society and welfare of the entire population maintained while minimizing extreme poverty and the economic deprivation of any part of society The concept of economic growth is defined as the growth rate of total economic output, including the contribution of capital accumulation in this output (Khan, 2001) Growth is still a necessary but not sufficient condition for economic growth Among the most

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important inputs to economic growth are financial resources and access to these resources in all spheres of economic activity (Levine, 1997) This explains the reason why the government should care about the shadow economy because the main goal of the government is the economic growth but to achieve the goal, they should facilitate the financial development and interestingly, the financial development has mutual relationship with the shadow economy logically Indeed, in the research of Straub (2005) and Elgin & Uras (2013b) showed the negative effect of shadow economy on the financial development They argued that the government policies related to taxes will increase the size of shadow economy and then increase in shadow economy will inhibit the financial development Actually, when the taxes are lower, it means that the costs of operating in official economy is lower or the opportunity of operating in shadow economy is higher Whereas there are empirical evidence from research of Capasso & Jappelli (2013) stated that the financial development will shrink the size of shadow economy

The government should intervene in developing policy process of financial development to reach the goal of economic growth The role of financial institutions and their policies in economic growth is addressed in Stiglitz and Stiglitz (2000), showing that the design of financial institutions and policies plays an important role to the point of economic growth Furthermore, the changes in the policy which affect positively the financial development will be considered as

a shock created by financial development and will affect in shadow economy On the other hand, the shock created by shadow economy here in this research is considered as the causes which will increase the size of the shadow economy such as the increase in taxation (because this study focused on the shadow economy created by tax burden) The additional point is that when the government has any actions which affect the financial development will somehow create a shock

on shadow economy and this section will be discussed in section 4: results and discussion

Obviously, financial markets are the intermediaries of the economy, contributing to capital accumulation and technological innovation, and are closely linked to economic growth The theories emphasize that the development of the financial system is an important factor of the economy in the long-term The developed financial system can facilitate economic growth through multiple channels According to Drake (1980); Fritz (1984); Garcia and Liu (1999); Beck and Levine (2005), these channels include:

(i) Providing information on feasible investments, to effectively regulate the capital;

(ii) Monitoring the corporates and corporate governance in public sector;

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(iii) Diversification of risk;

(iv) Mobilizing and aggregating savings;

(v) Facilitating the exchange of goods and services; and technology transfer

The financial sector serves many of the important functions of the economy, as countries with low levels of financial development will deal with capital deficits, lack of competitiveness, and financial injustice as well as limited ability to gather information for lenders, (Bose et al., 2012) It is the fundamental for the development of shadow economy and therefore again it appears to a relationship between the financial development and shadow economy

When Love and Zicchino (2006) did a research about financial development for business experience on financial constraints, which is a criterion for distinguishing between low levels of financial development and high levels of financial development countries The countries with high developed financial system are places where firms are more experienced in the financial constraints of the business as well as the financial market’s products Thus, it will raise the opportunity cost of operating in shadow economy

2.1.2.1 The origin of financial development

The concept of financial development is not new in literature However, understanding the concept clearly will help to measure and observe it precisely This part will introduce the origin

of financial development and the determinants of financial development Including institutions, macroeconomic elements, geographic factors and others

2.1.2.1.1 Institutions

Institutions are mentioned because it played an important role in creating the concept of financial development Obviously, the regulations affecting some major related variables such as property rights, the enforcement of agreements, accounting standards, etc which definitely affect the financial development (Porta, Lopez-de-Silanes, Shleifer, & Vishny, 1998) According to Beck and Levine (2005), a country with strong regulation in terms of efficiently enforcement of agreements will have higher financial development On the other hand, country with weak enforcement of regulations will have lower financial development Indeed, the disclosure of information, accounting standards, operation of banking system regulation and financial insurance are all defined in the regulations which have a strong effects on financial development (Mayer & Sussman, 2001) A deeper analysis of this issue is the interest group and its influence

on the financial development, a recent study of political economy mentioned that the interest

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group may affect the regulations in order to maximize their benefits Then, it obviously affects the financial development (Pagano & Volpin, 2001) Additionally, the study of Rajan and Zingales (2003) stated that the trade openness and financial openness are affected by the interest groups who can interfere in the financial market and the financial development is only better with both openness environment

In short, institutions plays an important role on financial development The financial development will depend somehow on the development of institutions of that nation However, due to the limitation of time and data, this research did not take into account the institutions as a variables in our model

2.1.2.1.3 Geography

The concept of geography initially seem not relevant with financial development concept However, in some studies, researchers have pointed out the relationship between geography and financial development Indeed, in the research of Gallup, Sachs, and Mellinger (1999), they found out that tropical climate countries which are near the equator will have poor production of crop and then it will lead to institution issues Moreover, the studies of Sachs, Warner, Åslund, and Fischer (1995), Easterly and Levine (2003); Malik and Temple (2009) stated that the countries with landlocked will have less chance to open their trade as well as the opportunity for building

up the comparative manufactured goods Then, it will lead to less openness of trade and as a result, the financial development will be counted on The last area which researchers focuses on

is the resource endowment and economic development In the study of Isham, Woolcock,

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Pritchett, and Busby (2005) the developing countries with rich natural resources will develop their countries through just identical channel and it may put the countries in risky situations and then it affects the economic development as well as the financial development as a result

In short, geography does affect the financial development in terms of demand side of financial development or the quality of institutions

2.1.2.1.4 Other considered variables

There are still some other variables affecting the financial development which are economic growth, the income, population, etc Greenwood and Jovanovic (1990) and Saint-Paul (1992) concluded that when a country has a strong economic growth, they will have costs advantages of financial intermediaries Indeed, when the economic grows, there are more money flow – in the markets via financial channels (intermediaries) such as banks, it will reduce the costs of these transactions Additionally, this conclusion leads the author to the belief that there are the positive relationship between financial development and shadow economy

In addition, the relationship between income and financial development empirically tested through the study of Levine (1997), Easterly and Levine (2003) and Beck and Levine (2005) The research of Jaffee and Levonian (2001) also found out a specific evidence of the relationship in banking development by using the data of bank assets, numbers, and employees The result shows the positive relationship between income and banking system development

Last but not least, the financial development is also affected by the culture (especially religion and language) In fact, culture helps to foresee the differences in the enforcement of creditor rights as well as investor rights and from that it may affect the trade openness (Stulz & Williamson, 2003) Furthermore, the study of Djankov, Glaeser, La Porta, Lopez-de-Silanes, and Shleifer (2003) opened a new variable which may affect financial development is the state ownership

2.1.2.2 General determinants of measuring financial development

A direct result from McKinnon and Shaw (1973) and Shaw (1973) showed that interest rate regime, reserve requirements and credit programs were the main causes on the financial development Indeed, they found out the negative result when a country having high interest rate, high required reserves and direct credit programs tends to have lower financial development level

In the study, the problem of financial development is the allocation of credits Obviously, if the government interfered to the process of credit allocation, it would be likely a corruption because the money will go to the “interest sectors” Therefore, a policy which can eliminate the interest rate ceilings, set the required reserve lower and liberate the financial systems form government

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intervention is crucial for the financial development This review also motivate the author to pick the credit for private sectors and credit from financial sectors to represent the financial development because it is suitable for the current research condition of the author in terms of time and data constraint

2.1.2.3 The potential determinants

There are potential determinants which can represent the financial development After reviewing many selected sources, there are some variables which can help to be the “face” of financial development These variables which may cause the endogeneity problems are not taken

in to account

The financial variables

The easiest way to measure the financial development is to take the direct variables which directly affect the financial development According to McKinnon and Shaw (1973), the financial development will be changed by the change in interest rate regime, reserve requirements and credit programs Therefore, taking financial variables to represent the financial development is reasonable Moreover, Aghion, Howitt, and Mayer-Foulkes (2005) took the credit multiplier as the main parameter to measure the financial development Thus, it confirmed our point of view

on the representative of financial development

Institutional variables

An institutional variable may be considered in the research to measure the financial development According to Porta et al (1998), the legal variables will be a potential determinant for financial development In his study, he suggested a dummy variable to identify the financial development However, the use of institutional determinants will be considered based on the characteristics of the data

Policy variables

On of other potential determinants for financial development is policy variables which will examine the macroeconomics policy variables and its effects on the variance of financial development (Demetriades & Luintel, 1996) The elements of financial policies and trade openness will be taken into account when using these variables It will be great if we have the data covering all these variables

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2.2 Review of empirical studies on the relationship between financial

development theory and shadow economy theory

Theoretically, the study of the relationship between financial development and the shadow economy was founded by Becker (1968) study, which was the economic impact of criminal acts Becker (1968) argues that firms in the market will face the option of benefiting from one side of the benefits of shadow economy operations over paying for detection and fines In the shadow economy, entrepreneurs in particular measure the benefits of informal sector operations, such as evading heavy taxes or avoiding the cost of doing business with compliance in comparing with the costs of legally operating and other opportunity costs, e.g., and utilities for official beneficiaries of government policies When the benefits of operating in the shadow economy are more than the cost of paying for it when discovered by law, businesses tend to increase their activities in the shadow economy

The theories discussing the financial system are one of the special agencies that affect the costs and benefits of the informal sector, thus affecting the shadow economy in the overall economics (Straub, 2005); (Dabla-Norris et al., 2008); (Blackburn et al., 2012); (Bose et al., 2012); (Capasso & Jappelli, 2013) For example, the impact of financial development is an increase of the opportunity cost of operating the shadow economy, which is to reduce the barriers

to capital gains with lower costs, incentive policies, and increased government investment driving the companies into the formal sector (Capasso & Jappelli, 2013)

First, Straub (2005) develops a theoretical model in which firms measure the benefits and costs of operating in the formal sector and the shadow economy In particular, the benefits from the formal sector are: the use of public resources such as working with state financial institutions These state agencies allow and advise businesses and companies to access financed resources effectively, including funds from government for areas or products promoted by the government However, experienced entrepreneurs may also be able to measure the cost they have to pay when they choose to enter the formal sector, which are fees and taxes Therefore, this model suggests that enterprises must provide the smallest initial registered asset level and contemporaneously participate in the formal sector with capital requirements for investment and production However, these entrepreneurs are even not able to afford this low initial capital because of the cost of registration and credit limits for businesses, which keep them operating in shadow economy (Straub, 2005) Business people will borrow capital from the shadow economy despite the higher cost of capital Finally, Straub (2005) concludes that the lowest initial capital level of

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enterprises is the major benefit of operating in the official (formal) economy deriving from support packages from government financial institutions which cover small and medium enterprises with low interest rates on the comparison between the formal and informal sector The reduction of binding legal obligations on the creditor's rights is obvious and it also reduced level

of ambiguity and tax obligation clause While the disadvantages of taking part in the formal economy cause the increase in participation costs, which may include costs of business creation, fees and taxes After 8 years, in the study of Elgin and Uras (2013b), they claimed that an increase

in size of shadow economy will lead to a decrease in financial development Indeed, Elgin and Uras (2013b) employing the data from 152 countries in the period 1999 – 2007 conducted a research on how financial development affects the shadow economy and vice versa His research showed that financial development and shadow economy have mutual effect In fact, the financial development will be constrained if the shadow economy gains the advantages On the other hand, the shadow economy will be narrowed down if the level of financial development improves This findings is obviously the evidence of the mutual relationship of shadow economy and the financial development

The formal economy vs shadow economy by Straub (2005) The arguments based on “low initial registered capital of enterprises”

Lower interest rates, incentives in government

incentives when registering low initial funding Creation fees

Reduce legal obligations on the rights of

creditors when initial low initial capital Other fees and taxes

Clearance of tax obligations and duties Credit limit

Moreover, Gobbi and Zizza (2007) found out that the financial development does not significantly affect the size of shadow economy but the reverse is statistically significant Indeed, the shadow economy affected the financial development In this study, Gobbi and Zizza (2007) used the data from 1997 to 2003 for Italian debt market The recent research of Berdiev and Saunoris (2016) argued that an underdeveloped financial sector is likely to be abused by subjects

in the shadow economy (securing loans or hiding funds), while the developed financial sector is being innovated and providing better financial services (e.g., the emergence of more optimal services from mutual funds and debt securities such as collateralized debt obligations), so the opportunity cost to produce in the shadow economy is higher In addition, advances in the formal financial market bring more alternatives than those of the shadow economy, such as the

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legalization of business operations Berdiev and Saunoris (2016) also pointed out that the transparency of government agencies provides protection against corruption and manipulation of public property to private property as well as unfair access to capital and contract execution, such

as economic contracts or tenders However, the existence of the shadow economy also contributes

to the weakening of government agencies, the inadequacy of budgets for government operations leads to a decline in both quantity and quality of public goods If there are no effective government intervention, it would be possibly by legislation as the alternative solution Additionally, Habibullah, Din, Yusof-Saari, and Baharom (2016) also did a same research to analyze the relationship between the financial development and shadow economy for Malaysia in the period

1971 – 2013 The received result revealed that there was a negative relationship between shadow economy and financial development

Next, Capasso and Jappelli (2013) formulated the theoretical model where the firm chooses between receiving high assistance when requiring collateral for credit from financial institutions and getting low subsidies from production using internal capital sources This model assumes that entrepreneurs can get a lower cost of capital by providing collateral to financial institutions, as collateral is secured, the risk must be lower and business could negotiate at the low interest rate (costs of capital) However, the provision of collateral in parallel with the need to point out the economic activities of the business, the income, as a result, it leads to higher duties This understanding is so great that government representatives can use these financial intermediaries

to monitor the operations of debt-financed companies, the financial system reduces barriers to access to funds and credit through which prevent the act of tax evasion, thereby reducing the spread of the shadow economy Capasso and Jappelli (2013) continue to discuss their views on the choice between participating in these two highs or lows, the choice between the cost reduction benefits of participating in the receiving support area with highly supportive of formal sector and the benefit of hiding revenue when using internal capital In a nutshell, the decision of whether

an enterprise receives low cost capital from an intermediary financial institution or uses an internal capital source; it also comes along with the need to prove collateral for income and economic activity, and to bear higher costs and taxes, or to hide activities and revenues for less premiums and taxes Capasso and Jappelli (2013) also argued that the development of financial sector will increase the opportunity cost of evading taxes, or underground operations, or the opportunity cost of decreasing credit limit and the opportunity cost of not receiving new technology investment

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The formal economy vs shadow economy by Capasso and Jappelli (2013)

The arguments based on “choosing the credit technology of the business”

collateral assets and disclosure revenue sources Do not evade fees and taxes with

publicity activities

Get access to new technologies

Previously, Amaral and Quintin (2006) argued that in developing countries, formal workers tend to gain more experience, be more educated, and earn more than informal workers Research indicates that low-skilled workers face barriers to entry into the formal sector In equilibrium, the author finds the characteristics of informal and informal workers differ systematically, although the labor market is perfectly competitive The informal sector is characterized by lower skill traits, because informal sector enterprises have less access to finance than the formal sector, and therefore firms in informal sector choose low-skilled workers to reduce capital use Furthermore,

a research of Bose et al (2012) for 137 countries with the data from 1995 to 2007 applied panel regression model examined the relationship between banking sectors and shadow economy This research concluded that banking sector development has negative relationship with shadow economy It means that the more developed banking sector, the smaller size of shadow economy

In the same year 2012, Blackburn et al (2012) found out that a country with lower level of financial development tends to higher size of shadow economy Moreover, a study of Bittencourt, Gupta, and Stander (2014) also found the evidence of the negative relationship of financial development over the shadow economy This study was conducted by collecting the data of 150 countries in the period 1980 – 2009 Indeed, they observed that the financial development caused the decrease for shadow economy Recently, Bayar and Ozturk (2016) conducted a research about the same topic with the data from European transition economies from 2003 to 2014 The author

of this research also found the negative relationship between the financial development and shadow economy

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2.3 Summary

Figure 1: Conceptual framework of shadow economy and financial development

To sum up, the shadow economy, according to Smith (1997), was a kind of market – based production of goods and services not in the estimation of official GDP regardless its legitimation (legal or illegal) A broader definition is that all economic activities avoiding regulation and taxation considered as shadow economy activities The concept of shadow economy in this research does not cope with illegal activities which is also considered as shadow economy activities such as burglary, drug dealing, etc

The first view point of Straub (2005) and Elgin & Uras (2013b) is about the effect of shadow economy on the financial development In fact, Straub (2005) pointed out the causes which may create a shock for shadow economy For instance, an announcement of government which will limit the access to public credit will encourage business to operate in shadow economy and then the size of shadow economy will be larger (Elgin & Uras, 2013b)

Furthermore, the causes of shadow economy are taxes and other social security’s burdens, the level of regulations enforcement, public services and the official economy First of all, to prove the effect of tax and social security’s burdens on shadow economy, there are many studies

on that such as of Del’Anno and Schneider (2005); Enste and Schneider (2000); Schneider (1994) and Friedman et al (2000); Johnson et al (1998) Secondly, the empirical work of Johnson et al (1998) found out the effect of the regulations on the development of shadow economy, it stated that the more sticky regulation, the greater size of shadow economy Thirdly, to maintain the quality of public goods and services, the government will tend to raise their income by increasing

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the taxes imposing on the institutions and businesses in the official sector These actions of the government will push the business toward the shadow economy Last but not least, in various studies of Bajada and Schneider (2005); Schneider and Enste (2013); Feld and Schneider (2010), the official economy will affect the choice of working or not working in shadow economy of people and institutions Indeed, when the economy is in the expansionary state, the official economy will help to raise the opportunity costs of working in shadow economy by providing good working conditions and facilitating the access to credits Finally, to measure the shadow economy, there are some suggested potential factors such as the monetary indicators (M2, taxation), labor market indicators (The labor participation rate, Growth rate of total labor force) and the status of official economy (GDP per capita) With these factors, it is quite easy to identify the potential variables for the research

The second view point of Capasso & Jappelli (2013) stated the effect of a change in financial development will negatively impact in the shadow economy It means that an increase

in financial development will lead to a decrease in size of shadow economy There are many causes of increasing or decreasing the financial development According to Drake (1980); Fritz (1984); Garcia and Liu (1999); Beck and Levine (2005), the developed financial system can facilitate economic growth through multiple channels The concept of financial development is usually gone with the economic growth Indeed, there are some other variables affecting the financial development which are economic growth, the income, population, etc Moreover, Greenwood and Jovanovic (1990) and Saint-Paul (1992) concluded that when a country has a strong economic growth, they will have costs advantages of financial intermediaries Thus, to understand deeper about the change in financial development, the causes of financial development were shown in a direct result from McKinnon and Shaw (1973) and Shaw (1973)

It showed that interest rate regime, reserve requirements and credit programs were the main causes on the financial development Indeed, they found out the negative result when a country having high interest rate, high required reserves and direct credit programs tends to have lower financial development level In the study, the problem of financial development is the allocation

of credits Thus, the potential determinants of financial development are financial variables, institutional variables and policy variables Logically, the easiest way to measure the financial development is to take the direct variables which directly affect the financial development Therefore, taking financial variables to represent the financial development is reasonable Moreover, Aghion et al (2005) took the credit multiplier as the main parameter to measure the financial development Thus, it confirmed our point of view on the representative of financial development Additionally, in our research, we acknowledged that the shock created by shadow

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economy is considered as the causes which will increase the size of the shadow economy such as the increase in taxation (because this study focused on the shadow economy created by tax burden) Moreover, the shock created by financial development in this research is considered as the causes which will increase the financial development such as the increase in credit supply

Finally, the recent studies about the relationship between shadow economics and financial development of Straub (2005); Dabla-Norris et al (2008); Blackburn et al (2012); Bose et al (2012); Capasso and Jappelli (2013) show the negative relationship between financial development and shadow economy Interestingly, there are some research show the mutual relationship of the two concepts such as the study of Elgin and Uras (2013b) In short, we see there may be a mutual relationship between shadow economy and financial development

Figure 2: The technical structure to deal with data

There are some concerns about the financial development and shadow economy except the

2 – way relationship issue Firstly, there are many variables should be taken into account when

we measure the financial development as we discussed in section 2.1.2 Thus, if we only use 1 variable, it cannot represent the financial development However, with the limitation of time and

Data

POLS FEM REM SGMM

Shadow Economy

P - VAR

Financial Development

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data, in this study, the author used 2 variables to represent the financial development aligned with the study of Elgin and Uras (2013b), Berdiev and Saunoris (2016), Mai and Schneider (2016) and Medina and Schneider (2017) which are:

1 Credit for private sectors: Credit provided by domestic credit institutions to the private sector (creditprivate)

2 Credit from financial sectors: Domestic credit from the financial sector includes total credit for other sectors and net credit to the government (creditfinancial)

These measurements are calculated based on GDP, data for the measurement is from World Bank Development Indicators, ADB and Euro monitor

The measurement of shadow economy size is also the challenging part when doing this study The shadow economy is known as the economic activities and the incomes avoiding the control of governments and taxation system (Del’Anno & Schneider, 2005) The estimation of the size of shadow economy is therefore difficult because individuals and organizations operating

in shadow economy tend to hide their activities Thus, there are some academics who try to find out the way of measuring the shadow economy Indeed, there are generally 3 ways of measuring shadow economy and Đức, Thịnh, and Nhung (2015) listed 3 main methods of measuring shadow economy including applied dynamic models with multiple indicators, direct and indirect methods The first method based on the dynamic multiple indicators – multiple causes model to measure the shadow economy Indeed, the size shadow economy variable is considered as the variable affected by the group of observed macroeconomic variables Additionally, the direct method is based on the micro – survey (surveying and auditing) The accuracy of this method depends much

on the way of building and developing the questionnaires and the quality of interviewees who are paid for the survey and other aspects The final method is indirect method which will exploit the economic variables and other variables such as the differences between the national (current) accounts and national expenses, the differences between the official number of labors and the actual number, the money demand approach, etc to calculate the size of shadow economy This study will estimate volume of shadow economy based on money demand which is developed by Tanzi (1983) , Cagan (1958) and recently Epaphra, M., & Jilenga, M T., (2017) Indeed, Tanzi (1983) estimated the demand for currency and employed the results to measure the size shadow economy established by the relationship between the demand for money and the pressure in the US tax in period of 1919-1955 Besides, Tanzi (1983) demonstrated that most transactions in the shadow sector, which is generated so as to prevent oversight from the government, are primarily performed by cash Therefore, the increase in demand for cash somehow reveals the increase in shadow sector

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The money demand method has been used many authors in order to measure the size of shadow economy involving Bhattacharyya (1999), Klovland (1984), Bajada (1999), Schneider (2002), Alm and Embaye (2013), Đức et al (2015) Hence, this study is going to apply the money demand method following Tanzi (1983) and also inherit some adjustments from Alm and Embaye (2013), Đức et al (2015) in order to archive more appropriate estimation for developing countries This study employed tax burden factor (𝑻), private expenditure (𝑪), gross national income (𝑰), deposit interest rates (𝑹), GDP per Capita (𝒀), thereby estimating an equation below with money

in circulation over total money supply M2 ratio (𝑪𝑴/𝑴𝑺) as dependent variable:

𝒍𝒏(𝑪𝑴

𝑴 𝑺)𝒊,𝒕= 𝜸𝟎+ 𝜸𝟏𝒍𝒏(𝟏 + 𝑻)𝒊,𝒕+ 𝜸𝟐𝒍𝒏(𝑪/𝑰)𝒊,𝒕+ 𝜸𝟑𝒍𝒏𝑹𝒊,𝒕+ 𝜸𝟒𝒍𝒏𝒀𝒊,𝒕+ 𝜺𝒊,𝒊 (1)

To estimate the equation, this study will utilize various techniques for panel data including pooled ordinary least squared (POLS), fixed effects model (FEM) and random effects model (REM) In which, POLS technique does not take into account the specific characteristics of each country in the model, FEM considers the specific characteristics of each country in the model, but it comes with a very strict assumption that the individual characteristics have to be fixed and does not change over time, meanwhile, REM allows the random countries characteristics which are treated as another error-term in the model Moreover, this study will also employ System Generalized Method of Moments (SGMM) so as to deal with endogeneity due to including order one lag dependent variable

3.2 Econometric models

According to Đức et al (2015), the most prominent methods are money demand method and dynamic model method Both methods are applied in many recent research in order to estimate the size of shadow economy of many countries for 50 years The money demand approach is developed by Tanzi (1983) based on the previous study of Cagan (1958) about the relationship between the money demand and the tax burden in United States in the period 1919 –

1955 Tanzi (1983) estimated the demand of money and used this results to measure the size of shadow economy of US in the period 1929 – 1980 The assumptions in the study of Tanzi (1983)

is that almost transactions in shadow economy using cash to avoid the supervising activities from the government; as a result, it will lead to the increase in size of shadow economy and then the demand for money Applying money demand approach, Tanzi (1983) used the regression model

to analyze the effect of different factors such as income of people, payments, deposit interest rates and tax burden on money demand The residuals in the estimated model is considered as the increase in the money in circulation Additionally, Tanzi (1983) also assumed that the money in circulation in official economy and shadow economy is similar and hence, the size of shadow

To estimate the size of shadow economy, the research will follow these steps below:

1 Inheriting from the model of Tanzi (1983), the author collect data about tax burdens, household consumptions, interest rate, GDP per capita, unemployment rates to estimate the value of CM/MS following the below model:

MS is the money supply and we took the data of M2 as the representative

 Tax T: the total income from tax over GNI Income from taxes comprises all taxes payables to the state

 Personal consumptions C/I: it includes the actual consumptions and estimated consumptions of individuals for goods and services

 The deposit interest rate R: the opportunity cost of holding money

 GDP per capita Y: GDP per capita calculated by Purchasing Power Parity method

2 The coefficients γ of the model (1) after the estimation is substituted for the model (1), then we have the model (2) (with fixed coefficients)

3 Assume tax T = 0 and the coefficients of independent variables are unchanged, we will calculate the amount of money when there is no effect of the shadow economy (when tax

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T = 0) and the amount of money when existing the shadow economy (when tax T ≠ 0) The official money in circulation is identified by the ratio of Gross National Income (NI) and money supply In the consistent with Đức et al (2015), we assume that the money in circulation in official economy and shadow economy is equivalent Hence, the size of shadow economy may be calculated by multiplying the money in circulation with the amount of money

4 Applying the above calculation for each country respectively, we will receive the result for the size of shadow economy in the research sample

Furthermore, according to Berdiev and Saunoris (2016), the level of economic growth have

a significant effect on the size of shadow economy and as well as the financial development On the other hand, the more prosperous nation will have higher level of financial development and smaller size of shadow economy Contemporaneously, the larger size of shadow economy together with lower level of financial development will keep the economic growth in low level Therefore, to control these aspects, author added a logarithm variable of GDP per capita in the P – VAR equation when we examine the relationship between financial development and shadow economy

After identifying all the related variables and the estimation methodology, the author chose the panel vector auto – regression model in order to control the 2 – way relationship between financial development and shadow economy (P – VAR) This is the technique to estimate contemporaneously as system of equations which considered the financial development variables and shadow economy variables as endogeneity (Berdiev & Saunoris, 2016; Holtz-Eakin, Newey,

& Rosen, 1988; Love & Zicchino, 2006) Because of the two – way relationship between financial development and shadow economy, it leads to the deviation of the estimation Additionally, the relationship between the two variables is observed by a time series data with identical lag, thus a dynamic model will work better than static model in this case Contemporaneously, the result of

p –VAR model will allow us to build impulse - response function to illustrate the development

on time basis of 1 variable (such as shadow economy variable) right after a shock on another variable (such as financial development variable) (Berdiev & Saunoris, 2016) Therefore, we could observe the whole dynamic process from very first shock to the long – term stable status of

a variable

Before taking the panel vecto autoregression (P – VAR), we conducted the unit root test to avoid the spurious regression Moreover, the optimal latency test is also applied to ensure the efficiency of the model