The shadow economy can have major effects on economic activity of a formal economy, through the distortions it implies for various economic indicators of economic policy. Most research emphasizes on the incorrect information provided by official statistics on important issues such as unemployment, inflation, consumption, productivity and income distribution which may have serious implications for the type of policy pursued and the nature of the expected outcomes, with economic, social and national importance, which are not clear at first sight. At the same time this phenomenon is a challenge for social prosperity. Increasing the shadow economy reduces tax revenues and hence the quantity and quality of the goods and services being offered. To avoid deterioration in social services, tax rates and regulations may increase to combat the black economy. This reinforces incentives for tax evasion and recourse to the underground economy becomes a vicious circle. An analysis of the extensive literature enables consideration of the shadow economy as one of the obstacles to social development. At the same time, studies argue that it may affect positively the living standards of some people as it helps them increase their total revenues. However, it may also have a negative impact on the quality of life, as it privileges questionable quality of working life, health, safety, etc. We try to determine the social impact of shadow economy. The existing literature focuses so far on the consequences of the shadow economy. We employ linear regression of ordinary least square (OLS) to investigate the link between shadow economy and the financial sector. We used data for the years 2000 – 2017 from the OECD countries to investigate whether the underground economy influences the size and structure of the financial markets and how it affects the economic system. Policymakers can benefit from our results, as they can realize the benefits of limiting shadow economy on the financial markets.

Keywords: financial market regulation; Shadow Economy, Financial Sector Development.

JEL classification: G10, G11, G20, G40