Tax evasion, financial development and inflation: Theory and empirical evidence

Using a standard overlapping generations monetary production economy, faced with endogenously determined tax evasion by heterogeneous agents in the economy, we provide a theoretical model that indicates that both a lower (higher) level of financial development and a higher (lower) level of inflation leads to a bigger (smaller) shadow economy. These findings are empirically tested within a panel econometric framework, using data collected for 150 countries over the period 1980–2009 to enable a broad generalisation of the results. The results support the developed theoretical model, even after having accounted for the differences in the levels of economic development, the level of institutional quality that includes different tax regimes and regulatory frameworks, central bank participation in the economy as well as different macroeconomic policies.