Does the Underground Economy Hold Back Financial Deepening? Evidence from the Italian Credit Market

Abstract

The paper investigates the relationship between the underground economy and financial deepening. Entrepreneurs can only access external finance by disclosing credible information in formal documentation. This may be impossible for many informal producers, who lack proper accounting records. Similarly, irregular workers may have difficulty borrowing to finance consumption and house purchases. Using panel data on local credit markets in Italy, we find that the share of irregular employment has a strong negative impact on outstanding credit to the private sector. According to our estimates, a shift of 1 per cent of employees from regular to irregular work corresponds to a decline of 1-2 percentage points of GDP in the volume of business lending and of 0.3 percentage points in outstanding credit to households. By contrast, the feedback effects of financial deepening on the size of the informal sector are weak and statistically not significant. Applying a difference-in-difference approach that exploits the exogenous variation induced by the regularization program for immigrant workers launched in 2002, we also find that irregular labour has a negative effect on banks' decisions to enter local credit markets.

Keywords: irregular employment, bank lending, school drop-out, entry, branching, regularisation program

JEL Classification: G21, O17, R23