Financial inclusion can offset economic damage of informality

According to the researchers, financial inclusion expands access to formal banking, credit, savings and digital financial services, which helps individuals and businesses participate in formal economic activities. The authors test different aspects of financial inclusion using two broad indicators: financial market development and financial institution development.

A new analysis has found that the shadow economy continues to undermine economic growth, weaken public finances and create long-term structural risks. The authors show that stronger financial inclusion can soften these effects, but only if countries commit to improving access to formal banking and financial services.

The study, titled Shadow economy, financial inclusion and economic growth Nexus: evidence from developing countries and published in Humanities and Social Sciences Communications, examines data from 120 developing nations between 2002 and 2020. Using system GMM and difference GMM models to correct for endogeneity, the researchers deliver one of the most robust assessments to date of how informality and financial inclusion shape growth trajectories.

The study finds that informal economic activity reduces tax revenues, erodes institutional quality, limits investment in public infrastructure and depresses productivity. At the same time, financial inclusion acts as a stabilizing force, pushing firms and individuals toward the formal sector. The authors argue that inclusive financial systems help counter the harmful influence of the shadow economy, creating an important pathway to stronger and more sustainable growth.

How does the shadow economy influence growth in developing countries?

The authors explain that informality in developing countries ranges from small unregistered businesses and cash-based transactions to large unregulated operations that bypass taxation and government oversight. While this activity may provide short-term income for vulnerable populations, its long-term effects on national economies are negative.

The analysis shows that a larger shadow economy leads directly to lower economic growth. This relationship holds across multiple measures and persists even after controlling for other influences. The researchers identify several pathways through which informality weakens growth. First, it reduces government revenue, limiting spending on infrastructure, education and health. These investments are essential for long-term productivity. Second, informal firms often operate with inefficient technologies and limited access to credit, which slows innovation and lowers competitiveness. Third, a large informal sector weakens trust in institutions and reduces compliance with regulations, creating a cycle that further entrenches informality.

The authors also highlight that the shadow economy disrupts macroeconomic stability. When large segments of economic activity go unrecorded, policymakers cannot accurately assess inflation, employment or productivity trends. Poor information reduces the effectiveness of economic planning and increases the likelihood of policy mistakes. The study notes that informality also discourages foreign investment, since investors see it as a signal of weak governance and high risk.

By providing new evidence across a long time frame and a large sample of developing nations, the study strengthens the conclusion that informality is a major drag on economic performance. It establishes that without targeted interventions, the shadow economy will continue to undermine growth potential and weaken state capacity in the developing world.

Can financial inclusion reduce the harm caused by the shadow economy?

According to the researchers, financial inclusion expands access to formal banking, credit, savings and digital financial services, which helps individuals and businesses participate in formal economic activities. The authors test different aspects of financial inclusion using two broad indicators: financial market development and financial institution development.

The findings show that financial inclusion has a strong positive impact on economic growth in developing countries. More importantly, the results indicate that financial inclusion weakens the negative relationship between the shadow economy and growth. As access to financial services expands, people and firms in informal sectors find incentives to join the formal economy. These incentives include better access to credit, improved financial security, lower transaction costs and greater opportunities for business growth.

The study demonstrates that when financial systems are more inclusive, the harmful effects of the shadow economy decline. Financial institutions reduce barriers for individuals who lack documentation or collateral, while digital financial tools enable easier registration, payment tracking and savings accumulation. This formalization process increases tax revenues, strengthens institutional accountability and enhances the accuracy of macroeconomic indicators.

The authors also discuss structural channels through which financial inclusion supports growth. Formal banking allows governments to track economic activity more accurately, helping them develop better policies. It also encourages investment in new technologies and enables households to manage risks more effectively. As the use of financial services grows, informal transactions decline, corruption reduces and trust in institutions strengthens.

The study confirms these findings using alternative measures of the shadow economy, including the MIMIC and DGE models. This reinforces the conclusion that financial inclusion acts as a stabilizing force in economies with high levels of informality. The authors argue that developing countries can significantly improve their long-term growth prospects by expanding access to financial services and fostering digital financial ecosystems.

What policy actions can strengthen growth and reduce informality?

The study provides a set of policy recommendations aimed at helping developing countries reduce the size of the shadow economy and improve economic performance. The authors argue that financial inclusion should be integrated into national development strategies, since it provides a pathway for informal workers and small businesses to join the formal sector.

Strengthening financial institutions is central to this approach. Countries must expand both physical and digital access points for banking services, improve regulatory frameworks and ensure that financial products are accessible to low-income and marginalized groups. The study notes that mobile banking, digital wallets and online financial platforms have become powerful tools for increasing inclusion, especially in regions where traditional banks have limited reach.

The authors also highlight the importance of financial literacy. Many individuals remain outside the formal financial system because they lack knowledge about available services or do not trust banks. Education programs aimed at improving financial awareness can help build confidence and encourage people to transition out of informal practices.

The study stresses the need for stable macroeconomic environments. High inflation, weak governance and political instability discourage formalization and undermine financial institutions. Countries must prioritize reforms that improve transparency, reduce corruption and strengthen rule of law. When institutions function effectively, individuals are more willing to engage with the formal economy and adopt financial services.

Investment in infrastructure is another important factor. Access to reliable electricity, internet connectivity and secure payment systems supports the expansion of digital finance. The authors argue that developing countries must build the technological foundation needed to support widespread financial inclusion and formalization.

The researchers also point to the value of targeted interventions. Programs that simplify business registration, reduce compliance costs and provide incentives for small enterprises to formalize can help shrink the shadow economy. Governments should also improve monitoring systems to identify sectors where informality is highest and design reforms accordingly.