Shadow Economy and Economic Growth Nexus in Developing Countries: What is the Role of Financial Inclusion?

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