Tackling the shadow economy through inflation and access to credit

How do changes in inflation and financial market development affect the size of the shadow economy? Previous studies show that lowering the tax rate, coupled with increasing the level of tax enforcement through policing and imposing high penalties for tax evasion may reduce the size of the shadow economy. While increasing the level of enforcement may be a viable strategy, most developing countries are unable to effectively enforce their tax laws. Based on empirical observations, we suggest that monetary authority could play an important role in this regard. Using a two-sector dynamic general equilibrium model of a small open economy, we demonstrate how monetary policy can be used to reduce the size of the shadow economy. The results suggest that, conditional on access to credit, a rise in inflation leads to a reduction in the size of the shadow economy. With little or no access to credit, such a policy will be ineffective. We evaluate alternative policy measures to achieve a targeted size of the informal sector.