Can financial sector reform help bring informal firms into the formal sector?

Thorsten Beck, Chen Lin, Yue Ma 13 October 2010

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While the global crisis has amply demonstrated the economic fragilities that a highly evolved financial sector can create, it is important not to “throw the baby out with the bath water”. The financial sector is critical to the economy. The important connection between financial development and growth is supported by a growing literature (Levine 2005).

Almost all the existing studies, however, examine the links between financial development and formal economic activities. Noticeably absent is an examination of the links between financial intermediary development and informal (unofficial) economic activities such as tax evasion. This is an important omission, as informality can impede economic growth in several ways.

  • Firms operating informally cannot make good use of market-supporting institutions and are therefore subject to underinvestment problems.
  • Doing business in secret may generate further distortions because of the efforts in avoiding detection and punishment.
  • The hidden resources may not find their most productive uses.

Understanding the relationship between financial intermediary development and informality helps understand an additional channel through which financial development can influence the process of economic development.

What does theory suggest?

The existing literature suggests several channels through which financial sector outreach might affect corporate tax evasion.

  • First, firms are more likely to hide outputs in an economy with underdeveloped market-supporting institution because they gain little from being formal. In countries with underdeveloped financial systems, firms thus have fewer incentives to become formal and have access to formal financial services.
  • Second, in order to evade the taxes, firms inevitably need to “cook the books” – manipulate their financial information.

From a bank’s perspective, tax evasion thus increases information asymmetry between borrowers and lenders and ultimately reduces access and increases financing costs for firms. Yet there might be a countervailing effect. In countries with more effective financial institutions, the presence of collateral might be less important to the creditors because the information gap between creditor and borrower is smaller and because the creditors can monitor the firms more effectively. Borrowers have thus less of an incentive to ensure completely transparent book keeping.

Two dimensions of the financial infrastructure of an economy can help reduce information asymmetry between borrowers and lenders. The sharing of positive and negative information about borrowers through credit information sharing helps financial institutions take more informed lending decisions (Jappelli and Pagano 2002).1 Higher branch penetration reduces the distance between lender and borrowers and again can help alleviate information asymmetries and thus reduce firms’ financing constraints (Beck et al. 2007).

New evidence on “banking sector outreach”

In recent research (Beck et al. 2010) we shed light on two specific channels linking financial intermediation and informality: better information sharing and physical branch penetration of banks, what we call “banking sector outreach”.

We use data from the World Bank-IFC Enterprise Surveys to measure both the degree of tax evasion and construct an array of firm-level control variables. Sample sizes vary between 250 and 1,500 companies per country and the sample includes formal enterprises of all sizes, different ownership types and from different locations, such as capital city, major cities, and small towns.

We construct the tax evasion variable using responses from the following question:

“Recognising the difficulties many enterprises face in fully complying with taxes and regulations, what percentage of total sales would you estimate the typical establishment in your area of activity reports for tax purposes?”

Using responses on this question, we construct two variables. The tax evasion ratio is one minus the share of sales reported for tax purposes, while the tax evasion dummy is one if a company reports that any sale goes unreported. The tax evasion ratio ranges from an average of almost 80% in Senegal to less than 3% in Chile, with an average across countries of 17%. While in Senegal, 99.4% of firms report tax evasion in their industry, in Chile it is only 14%.

We relate our measures of tax evasion to an array of financial sector indicators. In addition to a standard indicator of financial depth – private credit to GDP – we use geographic branch penetration, which is the number of bank branches per square kilometre and demographic branch penetration, which is the number of bank branches per capita (Beck et al. 2007). We use several indicators of the existence of a credit registry and its efficiency as measured by how much information is available from how many sources, about how many borrowers and how easily is it accessible.

Our final sample includes over 22,000 firms from 43 countries.

The empirical findings: Financial development reduces tax evasion

First, the existence and depth of credit registries is associated with a lower incidence and extent of tax evasion. The effect is also economically significant. Firms in countries with a credit registry are 20% less likely to evade taxes and the tax evasion ratio is 11% lower in these countries. Similarly, greater banking sector outreach is associated with a lower incidence and extent of tax evasion. A one standard deviation increase in bank branch penetration per capita is associated with a reduction in the incidence of tax evasion of 13.9% and a reduction of the tax evasion ratio of 10.3%.

Second, the relationship between information sharing and banking sector outreach varies significantly across regions within countries, as do firms’ decision to evade taxes. While we find a more muted relationship between information sharing, banking sector outreach and tax evasion for firms in the capital city, the relationship is even stronger for firms in small towns. Similarly, we find that the relationship between information sharing, banking sector outreach, and tax evasion, varies significantly across firms of different sizes. The effect of more effective credit information sharing and larger banking sector outreach is statistically and economically stronger for small than for large firms.

Third, the relationship between information sharing and banking sector outreach also varies significantly across different industries, as do firms’ decision to evade taxes. Specifically, firms in industries that are naturally more dependent on external financing, have higher liquidity needs, have higher growth opportunities, and are less likely to evade taxes in countries with more effective credit registries and higher banking outreach.

Our findings are consistent with theory. We would expect geographically more remote and smaller firms as well as firms with higher financing and liquidity needs to reap more benefits from better access to formal financial services. In horserace regressions, however, we find that it is mostly variation in firm size that can explain cross-firm heterogeneity in the relationship between credit information sharing, branch penetration, and tax evasion.

As a final robustness check, we focus on a more limited sample of 897 firms across 26 Central and European countries, many of which introduced credit registries or upgraded them in the early 2000s. These firms were interviewed in 2002 and 2005 so that we can directly observe whether there is a relationship between changes in the quality of credit information sharing and firms’ tax evasion. We confirm our results both for the level and the differential effect of credit information sharing on tax evasion, further alleviating concerns of simultaneity and endogeneity biases.

Conclusion

Our findings provide evidence on a critical link between informality and banking sector outreach. As more data become available, time variation in banking sector outreach as well as the introduction or upgrading of credit information sharing can be linked to tax evasion and informality.

References

Beck, T, A Demirguc-Kunt, MS Martinez Peria (2007), “Reaching Out: Access to and Use of Banking Services across Countries”m Journal of Financial Economics 85: 234-66.

Beck, T, A Demirgüç-Kunt and V Maksimovic (2005), “Financial and Legal Constraints to Firm Growth: Does Firm Size Matter?”, Journal of Finance, 60:137-177.

Beck, T, C Lin and Y Ma (2010), “Credit Information Sharing, Banking Sector Outreach and Corporate Tax Evasion”, Centre and EBC Discussion paper, Tilburg University.

Casson, Mark, Marina Della Giusta and Uma S Kambhampati (2010), “Formal and Informal Institutions and Development”, World Development, 38(2):137-218.

Jappelli, T and M Pagano (2002), “Information Sharing, Lending and Defaults: Cross-Country Evidence”, Journal of Banking and Finance, 26:10, 2017-45.

Levine, Ross (2005), “Finance and growth: Theory and evidence”, in P Aghion and S Durlauf (eds.), Handbook of Economic Growth, North-Holland Elsevier Publishers.

Miller, M (2003), “Credit reporting systems around the Globe: the state of the art in public credit registries and private credit reporting firms”, in M Miller (eds.), Credit Reporting Systems and International Economy, MIT Press.


1 In fact, tax information is often collected by credit registries or private bureaus and shared among financial institutions (Miller 2003).

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Topics:  Development Taxation

Tags:  taxation, tax evasion, financial development, informal sector

Professor of Banking and Finance, Cass Business School; Research Fellow, CEPR

Professor in Finance at Department of Finance, Chinese University of Hong Kong

Professor and Head of Economics Department at Lingnan University, Hong Kong

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