Mitigating the shadow economy through financial sector development in Indonesia: some empirical results

We examine the relationship between financial sector development and the shadow economy in Indonesia from 1980 to 2020. We estimate the size of Indonesia's shadow economy using the "Modified Cash to Deposits Ratio" approach. We then construct a long-term model using the size of Indonesia's shadow economy as the dependent variable. We set financial sector development as the main independent variable in our model. We use per capita real gross domestic product, the misery index, and foreign direct investment as control variables in our model. We find that financial sector development and the size of Indonesia's shadow economy have a nonlinear relationship that shows an inverted U-shape curve. The size of the shadow economy expands at the early stages of financial sector development to a turning point and decreases when financial sector development increases further. We also find that foreign direct investment curtails Indonesia's shadow economy. Additionally, increases in income expand Indonesia's shadow economy while misery index shows ambiguous results. We suggest the Indonesian authorities widen access for micro, small, and medium firms to the credit markets and enhance existing programs to reduce poverty and narrow the income gap in the country. These efforts help to narrow the size of Indonesia's shadow economy.