Accepted Manuscript

Interaction effect of tax evasion and legal system inefficiency on firms' financial
constraints

Germana Giombini, Désirée Teobaldelli, Friedrich Schneider

PII: S1059-0560(18)30052-2
DOI: 10.1016/j.iref.2018.01.009
Reference: REVECO 1565

To appear in: International Review of Economics and Finance

Received Date: 27 April 2015

Revised Date: 22 December 2017
Accepted Date: 21 January 2018

Please cite this article as: Giombini G., Teobaldelli Déé. & Schneider F., Interaction effect of tax evasion
and legal system inefficiency on firms' financial constraints, International Review of Economics and
Finance (2018), doi: 10.1016/j.iref.2018.01.009.

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 ACCEPTED MANUSCRIPT
Interaction effect of tax evasion and legal system inefficiency on firms’

financial constraints

Germana Giombini*, Désirée Teobaldelli † and Friedrich Schneider‡

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Abstract
This paper analyzes the joint effect of tax evasion and the legal system’s inefficiency on firms’

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financial constraints. Our theory highlights that each factor exerts ambiguous effects on the difficulties
encountered by firms that seek financing. However, under mild assumptions, our model leads to the

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conclusion that higher degrees of tax evasion and judicial inefficiencies both increase firms’ financial
constraints. Moreover, tax evasion and legal system inefficiency exert a joint impact as they mitigate
each other’s negative effect on credit constraints. We test our results by using firm-level data based on

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the World Business Environment Survey. The empirical findings confirm our theoretical hypotheses.
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Keywords: financial constraints, tax evasion, legal system efficiency.
JEL: D2, G3, H26, K4.
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* Department of Economics, Society, Politics, University of Urbino, Via Saffi 42, 61029 Urbino, Italy. Phone-
No: (+39)0722305565; Fax-No: (+39)0722305541. E-mail: germana.giombini@uniurb.it.
†
Department of Law, University of Urbino, Via Matteotti 1, 61029 Urbino, Italy. Phone-No:
(+39)0722303208; Fax-No: (+39)07222955. E-mail: desiree.teobaldelli@uniurb.it (corresponding author).
‡
Institute of Economics, Johannes Kepler University of Linz, Altenberger Straße 69, A-4040 Linz, Austria.
Phone-No: (+43) (0)73224688210; Fax-No: (+43) (0)73224688209, E-mail: friedrich.schneider@jku.at.

Acknowledgements
This paper benefited from comments and suggestions from two anonymous referees and participants at the 2012
annual meeting of the Italian Association of Public Economics and the 2015 annual meeting of the Italian
Economic Association. We are especially grateful to Giorgio Calcagnini, Roberto Dell’Anno, Giorgia Maffini,
Davide Ticchi, and Alberto Zazzaro for discussions and suggestions. The usual disclaimers apply. This research
did not receive any specific grant from funding agencies in the public, commercial, or not-for-profit sectors.
 ACCEPTED MANUSCRIPT
Interaction effect of tax evasion and legal system inefficiency on firms’

financial constraints

PT
Abstract
This paper analyzes the joint effect of tax evasion and the legal system’s inefficiency on firms’

RI
financial constraints. Our theory highlights that each factor exerts ambiguous effects on the difficulties
encountered by firms that seek financing. However, under mild assumptions, our model leads to the

SC
conclusion that higher degrees of tax evasion and judicial inefficiencies both increase firms’ financial
constraints. Moreover, tax evasion and legal system inefficiency exert a joint impact as they mitigate
each other’s negative effect on credit constraints. We test our results by using firm-level data based on

U
the World Business Environment Survey. The empirical findings confirm our theoretical hypotheses.
AN
Keywords: financial constraints, tax evasion, legal system efficiency.
JEL: D2, G3, H26, K4.
M
D
TE
C EP
AC
1. Introduction
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A large literature in economics and finance shows that various forms of financial development, such as
financial constraints, have important effects on the firms’ investments and ultimately on current and
potential growth of firms and the economy.1 While much is known about these relationships,
understanding the causes of firms’ financial constraints is still an important research issue deserving
attention.
As most determinants of firms’ financial constraints have their roots on the asymmetric
information between the creditor and the lender, we here consider two elements that exacerbate such

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asymmetry thereby reducing the possibility of the firms to obtain credit: the degree of firm’s tax
evasion and the quality of the legal system. Informality is not only a widespread and ever-increasing

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phenomenon around the world,2 it is also a factor playing a key role in increasing the asymmetry of
information between the lender and the borrower. To use the words of Beck et al. (2014, p. 765): “To

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evade taxes, firms inevitably need to manipulate their financial information (“cook the books”)… As a
result, information asymmetries and agency problems between borrowers and lenders increase with
tax evasion, which in turn affects banks’ lending decisions and requires banks to monitor firms more

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intensively (Lin et al. (2011)).”3 In addition, firms evading taxes may limit the information disclosed
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to third-parties to reduce the probability of being audited by tax authorities (e.g., Lenter et al., 2003;
Carrillo et al., 2017). Similarly, the country’s legal system might also contribute to the information
gap between lenders and borrowers and play an important role in determining the efficiency of
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financial markets. In countries where the legal system is more inefficient firms can manipulate the
information (e.g. cook the books) and report it to lenders more easily as expected sanctions for such
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behaviors are lower; in turn, the lower reliability of the information disclosed by firms is likely to
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strengthen firms’ financial constraints. The efficiency of the legal system and informality are also
related for other reasons. Since one of the costs of firms operating in the shadow economy is that they
cannot take full advantage of the legal system, operating informally is more attractive when the latter
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is more inefficient and therefore generate limited gains to formal firms.

In this paper, we analyze theoretically and empirically the effects of tax evasion and the legal
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system’s inefficiency on firms’ financial constraints as well as their joint effect to understand whether
they reinforce or mitigate each other.
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We build on the model of Zazzaro (2005) and develop a simple theoretical framework with
asymmetric information where entrepreneurs (borrowers) can have different quality and the banks
(lenders) operate in perfectly competitive markets. Banks can invest resources in screening activities
to better assess the quality of those applying for credit. Higher degrees of tax evasion and inefficiency
of the legal system have two effects: (i) they increase the costs of the screening activity, and (ii)

1
See for example King and Levine (1993), Calcagnini et al. (2015), Ductor and Grechyna (2015) and Kim et al.
(2016).
2
For comprehensive surveys of the shadow economy, black-market activities, and undeclared earnings, see
Schneider and Enste (2000), Feld and Schneider (2010), Buehn and Schneider (2012).
3
On the link between formality and access to credit see, for example, Johnson et al. (2000), Straub (2005), and
Dabla-Norris and Feltenstein (2005).

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reduce the amount of resources the bank can recover in case the project fails. These two effects in turn
affect the optimal amount of screening of the bank in opposite directions and, therefore, financing
constraints as we show that there is a positive monotone relationship between the amount of screening
and financing constraints (here intended as the share of good projects that are credit rationed).
In particular, more tax evasion and inefficiencies of the legal system both increase the cost of
screening and, therefore, reduce the bank’s optimal equilibrium investment in this activity; this
reduces the amount of credit to good entrepreneurs and increases financial constraints. However,
higher tax evasion and inefficiencies of the legal system also reduce the amount of resources the bank

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recovers when the project fails; this increases the incentive of the bank to invest in screening in order
to finance more good projects which have a lower probability of failure; hence, this effect reduces

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financial constraints. The result is that higher levels of tax evasion and judicial inefficiency generally
have ambiguous effects on financial constraints.

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We show that under mild conditions (such as a limited size of the income generated by
unsuccessful projects) the former effect is likely to dominate, so that higher tax evasion and judicial
inefficiency are associated to more firms’ financial constraints. We also show that tax evasion and

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judicial inefficiency mitigate each other’s negative effect on credit constraints. When the judicial
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system is very inefficient, the screening technology is quite costly and the optimal investment in this
technology is relatively limited. Hence, an increase in tax evasion that further worsen the efficiency of
screening will have a small effect on the level of screening chosen by the bank. In turn, the low
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reduction in the screening effort causes a small reduction in firms’ financial constraints.4
We test our hypotheses by an empirical model that analyzes the joint impact of the two variables
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of interest and then evaluate the marginal effect of tax evasion on the financial constraints faced by
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firms in terms of the legal system’s (in)efficiency.

We use firm-level, cross-country data from Voices of the Firms 2000 (Batra et al., 2002), which
is based on the World Business Environment Survey (WBES). The data set contains firm-level data
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for the period 1999–2000 on about 10,000 firms located in 80 different countries. These firms were
interviewed randomly, and the data set includes at least 100 interviews for each country. We focus on
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firms’ self-reported tax compliance, a proxy for informality. Our empirical strategy is based on both
ordinary least-squares (OLS) estimates, which yield a useful benchmark, and a Probit specification.
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We control for a wide range of variables that account for firm- and country-specific characteristics in
order to reduce the possibility of omitted variables. Moreover, we employ a two-step estimation so as

4
In other words, to simplify the explanation one could consider the extreme case where the three variables of our
analysis (credit constraints, efficiency of the legal system and tax evasion) are binary, so that firms are credit
constrained or not, the legal system is efficient or inefficient, and firms fully evade taxes or comply. Consider
first the case where both the legal system is efficient and firms do not evade taxes; in this case the information
transmitted by the firms to the banks is fully reliable and there are no financing constraints. If now firms evade
taxes, banks will consider the information transmitted unreliable and will constrain credit to firms; this shows
that tax evasion has a large impact on financial constraints when the legal system is efficient. Consider now the
case where, together with firms evading taxes, also the legal system becomes inefficient; clearly, this contributes
to increase the asymmetric information between firms and banks but its effects on firms’ financing are limited
because banks already constrain credit.

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to address the problems of a possible endogeneity bias and reverse causation (i.e., from credit access
to tax evasion). We use measures of corruption, availability of laws and regulations and tax
administration, which are often viewed by firms as obstacles to their business, to instrument for firm-
level informality. The results obtained here indicate that the marginal impact of tax evasion on a firm’s
financial constraints decreases with decreasing legal system efficiency; in other words, tax evasion and
judicial inefficiency mitigate each other’s effects on credit constraints. Our findings are robust to the
inclusion of a wide array of control variables and instrumentation.
The contributions of this work are at least two. First, it provides a theoretical and empirical

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analysis of the interaction between tax evasion and the inefficiency of the legal system in affecting
firms’ financial constraints, which to best of our knowledge has never been studied before. In

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particular, the works analyzing the impact of the legal system on firms’ financial constraints all
neglect the role of tax evasion (e.g., La Porta et al., 1997; Beck and Levine, 2005; Jappelli et al.,

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2005). The literature on the link between firms’ financial constraints and tax evasion has generally
focused on the opposite direction of causality, i.e. on how financial constraints affects the decision of
the firms to evade taxes or to go underground (e.g., Dabla-Norris and Feltenstein, 2005; Bose et al.,

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2012, Capasso and Jappelli, 2013), and not on how tax evasion affects the possibility of obtaining
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credit. Gatti and Honorati (2008) and Giombini and Teobaldelli (2010) are the only exceptions and
find that greater tax compliance is significantly associated with improved access to credit. As these
latter works only address the issue from an empirical perspective, our work also contributes to the
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literature by presenting a theoretical analysis on the possible channels through which tax evasion
affects financial constraints.
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Second, we believe that understanding whether tax evasion and the inefficiency of the legal
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system mitigate or reinforce each other in affecting financial constraints may have important policy
implications. To better understand this point, let us consider a country that wants to reduce firms’
financial constraints by improving tax compliance and/or the efficiency of the legal system. If tax
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evasion and inefficiencies of the legal system had independent effects on firms’ financial constraints,
then the government could focus on either reducing tax evasion or improving the efficiency of the
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legal system to meet a certain target. If instead the two mitigate each other, then either reducing the
level of tax evasion or increasing the efficiency of the legal system might generate limited results in
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terms of reduction of firms’ financial constraints (or require large improvements, and therefore
resources, in the policy instrument chosen) given that the marginal effects of lower tax evasion and
legal system inefficiencies are small in this case.5 This implies that a policy aiming at improving
firms’ access to credit in such circumstances requires both the reduction of tax evasion and the
improvement of the legal system in order to be effective. This in turn means that a government that
cannot improve one of these two dimensions (e.g., for the lack of resources or for political economy
constraints), it will have limited incentives to implement the other available policy in the first place
and the status quo is likely to prevail. On the other hand, an exogenous shock that reduces tax evasion

5
Recall that we are considering a country with high tax evasion and inefficiencies of the legal system.

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makes the marginal effect of improvements of the legal system on firms’ financial constraints much
higher, which then provides high incentives to the government to improve the legal system.6
In other words, when tax evasion and the inefficiency of the legal system mitigate each other in
affecting financial constraints, the adoption of policies improving the firms’ access to finance are more
likely to be implemented when the government can act along both dimensions; if instead only one kind
of policy (i.e., a reduction of tax evasion or a more efficient legal system) is available, the incentives
for policy reforms fade down but they eventually increase once exogenous shocks or virtuous policies
in the other area materialize.

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The rest of the paper is organized as follows. Section 2 briefly reviews the related literature and
summarizes the theoretical hypotheses. Section 3 presents a simple theoretical model. In Section 4 we

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describe the data, provide summary statistics and discuss our empirical methodology. Section 5
presents the results. Section 6 offers some concluding remarks.

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2. Review of the Related Literature and Theoretical Hypotheses
We here explain that our work complements the two distinct strands of literature briefly described in

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the Introduction, i.e., research relating firms’ credit access to informality levels and research
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investigating the role that legal institutions, such as creditor rights, play in supporting credit markets,
while advancing new hypotheses to combine and fill the gap between them.
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2.1 The link between informality and firms’ financial constraints

Most of the works emphasizing the link between informality and the firms’ financial constraints have
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addressed this issue by pointing out that an entrepreneur who operates in the formal sector has better
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access to external financing and this affects the decision of the firm to produce in the informal sector.
For example, Dabla-Norris and Feltenstein (2005) model the cost of evading taxes as a form of credit
rationing by banks and construct a dynamic general equilibrium model to explore the impact of
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informal activity on public finance and aggregate economic performance. Their model simulations,
which are based on stylized data from Pakistan, show that macroeconomically sustainable rates of
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taxation may induce underground activity. Antunes and Cavalcanti (2007) calibrate a dynamic general
equilibrium model where formal firms may benefit from better access to outside finance and show
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how regulation costs and contract enforcement affect the size of the informal sector in countries with
different characteristics. Straub (2005) develops a model of how firms choose between locating in the
informal versus the formal sector and analyzes the channels through which better rule of law and
judicial enforcement may reduce informality.
Bose et al. (2012) use data from 119 countries for the period 1999–2005 to examine the effect of
banking development on the size of shadow economies. Their results indicate that, in a wide cross
section of countries, a well-developed banking sector (in terms of depth and efficiency) is associated

6
Obviously, one could think to the reverse case where an exogenous efficiency gain in the legal system provides
the right incentives to the government to implement policies reducing tax evasion.

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with a smaller shadow economy. Capasso and Jappelli (2013) propose and test a theory concerning the
impact of financial development on the underground economy. Their model predicts that financial
development—and the attendant reduction in credit costs—encourages firms to disclose more of their
assets and to invest in high-tech projects. This effect is stronger in mature sectors, such as
construction, retail, and tourism. In addition, judicial system efficiency reduces both the cost of credit
and the size of the informal sector. The empirical evidence on Italian microeconomic data for the
period 1995–2004 is in line with their model’s predictions and also shows that the more competitive
and innovative sectors have a smaller shadow economy.

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While the above-mentioned papers analyze the effect of credit constraints on the informal sector,
we are instead interested in the opposite direction of causality, namely the effect of the shadow

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economy on firms’ financing constraints. This line of research has not received much attention in the
literature with the exceptions of Gatti and Honorati (2008) and Giombini and Teobaldelli (2010). The

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former work employs firm-level, cross-country data from WBES “investment climate” surveys in 49
developing countries to investigate how the access to credit and external finance can affect
productivity in the presence of a large informal sector. They find that greater tax compliance is

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significantly associated with improved access to credit. Giombini and Teobaldelli (2010) also obtain
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that formality affects positively the access to credit.
This leads to our first hypothesis to be tested in the empirical analysis.
H1: The higher the level of tax evasion, the greater the probability that firms’ access to finance will be
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constrained, ceteris paribus.

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2.2 The impact of the legal system inefficiency on firms’ financial constraints
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The law and finance literature finds that in countries where legal systems are able to efficiently
enforce private property rights, support private contractual arrangements, and protect investors’ legal
rights, lenders are more willing to finance firms and financial markets develop. In contrast, legal
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institutions that neither support private property rights nor facilitate private contracting restrain
corporate finance and inhibit financial development (La Porta et al., 1997, 1998; cf. Beck and Levine,
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2005 for an extensive review of the literature). For example, Jappelli et al. (2005) explore, both
theoretically and empirically, how the judicial enforcement of debt contracts affects the amount of
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lending, loan interest rates, and default rates. They develop a framework in which improvements in
judicial efficiency reduce credit rationing and increase lending but have ambiguous effects on interest
rates. The authors test these predictions using both panel data on Italian provinces and a cross-country
sample. Their results confirm the theory: judicial efficiency is negatively correlated with (proxies for)
credit rationing and positively correlated with lending volume. In a similar spirit, Fabbri and Padula
(2004) study, both theoretically and empirically, the relationship between the quality of the legal
enforcement of loan contracts and the allocation of credit to households. By using data on the
performance of Italian judicial districts, they show that a better working of the judicial system reduces
both the probability of being credit-constrained and the cost of credit. Laeven and Majnoni (2005) also

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obtain that improvements in judicial efficiency and judicial enforcement of debt contracts lower the
cost of financial intermediation for households and firms in a large cross-section of countries.
Djankov et al. (2007) investigate the determinants of private credit in 129 countries. They find
that supporting institutions and also creditor protection (through an effective legal system) are
associated with higher ratios of private credit to GDP, especially in richer countries. Furthermore,
legal reforms designed to enhance creditor rights and information sharing are likely to improve access
to credit. Safavian and Sharma (2007) use firm-level data from 27 European countries in 2002 and
2005 to establish that access to bank credit increases when the effectiveness of creditor rights is linked

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to the efficiency of contract enforcement.
Thus, there exists a general consensus that legal protections for creditors and efficient courts

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lower the firms’ financing constraints. This leads to our second hypothesis:
H2: A more inefficient legal system reduces the capacity of firms to borrow from the financial market,

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ceteris paribus.

2.3 The joint effect of tax evasion and the legal system inefficiency on firms’ financial constraints

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While both tax evasion and judicial inefficiency are crucial for the ability of firms to access financing,
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it is also possible that they interact and their effects are nonlinear. Hence, in this paper, we also aim at
augmenting the existing literature by modelling and estimating the joint effect of tax evasion and
judicial inefficiency on firms’ financial constraints. In other words, we want to understand whether tax
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evasion and legal system inefficiency mitigate or reinforce each other’s negative effect on the ability
of firms to access financing. The model developed in the next section suggests that, under reasonable
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conditions, tax evasion and the inefficiency of the legal system attenuate each other’s negative effect
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on the ability of firms to access financing. Then, the less efficient the legal system, the less effect that
tax evasion has on firm financial constraints. While this is our preferred hypothesis, it is possible to
find arguments in favor of the opposite theory that in the presence of inefficient judicial system, the
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negative impact of tax evasion on firm’s financial constraints is greater.

The above considerations lead to our third hypothesis:
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H3: The less efficient the legal system, the lower (higher) the marginal effect that tax evasion has on
firm financial constraints, ceteris paribus.
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3. The Model
3.1 The framework
We propose here a modified version of the model developed by Zazzaro (2005) to analyze the effects
of investments in accounting standards and enforcement of contacts by courts on credit allocation and
social welfare.
We consider an economy with a measure one of entrepreneurs who can undertake a risky project
each requiring one unit of capital. All entrepreneurs have zero assets and therefore the financial
resources necessary to undertake the project comes from the financial system (banks). The market of

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lenders is perfectly competitive and banks raise funds at a fixed interest rate normalized to zero while
applying a gross interest rate to borrowers. Entrepreneurs and banks are risk neutral; the economy
lasts one period and the game cannot be repeated.
All projects are risky and generate a random payoff: > 1 in case of success, and 0 ≤ < 1 in
case of failure. There are two types of entrepreneurs, good and bad, who differ for the probability of
success; good entrepreneurs (G) have a probability of success 0 < < 1 while the probability of
success of bad ones (B) is < . The fraction of good entrepreneurs in the population is fixed and

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equal to .
We assume that the state imposes a tax rate on profits and the entrepreneurs may attempt to
avoid it. The share of tax evaded is private information of the firm and it is independent on the

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entrepreneur’s quality; therefore, the strategy of the lenders cannot be conditioned on . While the
degree of tax evasion is chosen after the project is financed and realized, firms planning to evade taxes

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organize themselves in such a way that it is more costly for external agents (and therefore also for the
lenders) to generate reliable information about their activities and ultimately about the quality of their
projects. In this respect, we recall here the discussion presented in the Introduction about the need for

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firms evading taxes to manipulate their financial information and for banks to monitor them more
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intensively (Beck et al., 2014; Lin et al., 2011). In addition, firms evading taxes may need to disclose
little information to financial institutions to reduce the probability of being audited by tax regulators
(Lenter et al., 2003; Carrillo et al., 2017).
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We also assume that such feature of the organization of the firm, and therefore the level of tax
evasion, is exogenous. Clearly, in reality, both the organization of the firm and the level of tax evasion
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are endogenous and optimally chosen by the firm which may take into account also the effects of these
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choices on the possibility of obtaining credit. However, since our interest here is on understanding
how a given level of tax evasion, whatever determined, interacts with the inefficiency of the legal
system in affecting financial constraints, and not what are the determinants of tax evasion, we believe
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that assuming the exogeneity of tax evasion (so ignoring the effects of financial constraints on it) is a
reasonable simplification that does not reduce the generality of our results.
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Projects can be evaluated by the bank and the higher the level of information and the more
precise will be the assessment of the bank about the applicant’s quality. The screening technology
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implies a cost equal to

= , , (1)
where denotes the total amount of information produced by the bank or its screening effort and is
the marginal cost for the provision of information. We assume that the marginal cost of information
is affected positively by the level of tax evasion and by the degree of inefficiency of the legal
system, i.e. ≡ , with , > 0 and , > 0. As we said above, higher degrees of tax
evasion are possible only if firms adopt less transparent organizations that makes more costly for

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third-parties to obtain accurate information on their activities.7 Similarly, banks bear a higher marginal
cost in the production of information about the quality of projects also when the legal system is more
inefficient because firms can manipulate the information (e.g. cook the books) and report it to lenders
more easily as expected sanctions for such behaviors are lower.
Following Zazzaro (2005) we will make use of two specific functional forms about how the
informational content from screening process translates into probabilities of financing good or bad
projects. In particular, we assume that the probability that the bank correctly recognizes a good project
when it has produced an amount of information is given the following expression

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| , !
Pr =1− 1− , (2)
where " > 0 denotes the effectiveness of one unit of information. In contrast, the probability that the

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bank makes a mistake and evaluates a bad project as a good one is8
| , !
Pr = . (3)

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From (2) and (3) and the assumption that the fraction of good entrepreneurs in the population is
follows that the probability of receiving the signal that the project is good is constant and independent
on the screening effort, i.e. Pr G = .

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The following assumptions guarantee that investment in screening is always optimal: (i) the net
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present value of good entrepreneurs is positive, %& = + 1− > 1, (ii) it is negative for the bad
ones, %( = + 1− < 1, and (iii) the expected net value of randomly selected projects is
negative, %) = %& + 1 − %( < 1.
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When the project is successful the lender pays the gross interest rate to the bank, while the
lender appropriates the payoff of the project when this is unsuccessful. However, the amount
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effectively seized by the creditor in the latter case is only a fraction * of the payoff as a fraction
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1 − * is wasted in bankruptcy procedures. We assume that higher levels of tax evasion and
inefficiency of the judicial system reduce the share of resources that the bank appropriates, i.e.
*≡* , with * , < 0 and * , < 0. This assumption captures the idea that it is more
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difficult for the bank to seize the resources generated by the firm when part of the production is hidden
to the authorities (higher ) and when the judicial system is less efficient (higher ).
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3.2 The equilibrium

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A more formally rigorous way of illustrating the link between screening costs and tax evasion would be to
define the variable Λ that summarizes the transparency of the organization of the firm and the easiness in
transferring outside the information, with ,Λ ⁄, ≡ Λ < 0 representing the fact that higher levels of tax
evasion are possible in organizations characterized by a lower degree of transparency. The screening
technology cost could then be written as = Λ , where the marginal cost of information is lower
when the organization of the firm is characterized by a higher level of transparency Λ , i.e. . , < 0.
However, using this formulation would lead to the same results at a cost of a lower clarity in terms of notation
and without addition of generality.
8
The probability of correctly recognizing a good project is increasing in and it ranges from the share of good
entrepreneurs in the population when there is no screening ( = 0) to 1 as tends to infinite. Similarly, the
probability of making a mistake and not recognizing a bad entrepreneur is decreasing in and ranges from to
zero.

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The assumption of perfect competition in the credit market implies that banks earn zero profits in
equilibrium and that the equilibrium credit policy maximizes the expected payoff of good
entrepreneurs. Moreover, as we already clarified, assumptions (i)–(iii) imply that banks have to invest
a positive amount of resources in screening. The assumption that the net present value of bad
entrepreneurs is negative (%( − 1 < 0) implies that the bank does not finance the project if the
entrepreneur has not passed the creditworthiness test.
The optimal debt contract is a combination of the level of screening and interest rate that
maximizes the expected payoff of the good entrepreneur

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max23,!4 E 6 & = − 1− + , (4)
subject to the participation constraint of the bank

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E 6 7 = Pr 28 + 91 − 8 :* , − 14 − , ≥ 0, (5)
where Pr is the probability of receiving the signal that the entrepreneur is good, 8 is the

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probability of success of an applicant that has passed a creditworthiness test with amount of
information produced . The feasibility constraint that the contract produces a non-negative return for
− ≥ 0.

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the entrepreneur reads:
The assumptions that banks operate under perfect competition implies that in equilibrium
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E 6 7 = 0. Therefore, using the fact that Pr = , from (5) we obtain the following gross
equilibrium interest rate
!= , >? A @ !
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∗
= ?@ !
− @ !
* , , (6)

where
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| !
8 = + − Pr = − − 1− , (7)
is the probability of success of applicants who have passed the creditworthiness test.9
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∗
The maximization problem (4) corresponds to the minimization of the gross interest rate with
respect to the level of screening . Hence, from the differentiation of (6) with respect to , taking into
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∗
account (7), we obtain that the optimal level of screening is implicitly determined by the following
equation
, 98 − 8′ : − 8′ 91 − * , : = 0, (8)
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with
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!
8′ = − 1− " . (9)
Also, note that the second order condition of our (minimization) problem reads − , 8CC −
8CC 91 − * , : > 0 and it is always satisfied as
8CC = −" D − 1− !
< 0. (10)
Proposition 1. The equilibrium contract in the credit market is defined by a combination of the
∗ ∗
gross interest rate and an optimal level of screening defined by (6) and (8) respectively. If the
∗
feasibility constraint, ≥ , is not satisfied, then there is no equilibrium in the credit market. 10

9
To obtain the expression of 8 in (7) we have used the expression of Pr | defined in (2).

10
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3.3 Comparative statics
We now analyze how tax evasion and the legal system inefficiency affect the equilibrium in the
credit market with particular attention to the firms’ financial constraints. In this respect, it is
immediate to verify from (6) that higher levels of tax evasion and inefficiency of the judicial
∗
system both increase the equilibrium interest rate .
Regarding the credit constraints, it is useful to observe that while there are good and bad
entrepreneurs not receiving credit in equilibrium, only the good ones have a positive net present value

PT
(%& > 1 ; the net value of the project of bad entrepreneurs is negative and, therefore, they would not
realize it with their own resources. This leads us to conclude that the share of financially constrained

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firms in this model is well represented by the good entrepreneurs who do not receive credit.
The number of projects financed in this economy is independent on the screening effort and equal

SC
∗
to . However, higher levels of the equilibrium screening effort increase the average quality of the
entrepreneurs financed as it can be observed from the fact that 8 in (7) is increasing in . In
∗
particular, as increases, the probability of success of the average project financed tends to the
probability of success
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of the good entrepreneurs, which means that banks make fewer mistakes and
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more good projects are financed. Hence, we conclude that the degree of firms’ financial constraints
(represented by the share of good entrepreneurs who do not receive credit) is decreasing in the amount
∗
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of screening . This means that the effect of tax evasion and the degree of inefficiency of the
∗
legal system on firms’ financial constraints can be found by computing the effects of and on .
∗
Remark 1. Higher levels of the equilibrium screening effort (implicitly defined by (8))
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increase the probability that good projects are financed and therefore reduce credit constraints.
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Hence, the effect of tax evasion and of the inefficiency of the legal system on firms’ financial
∗
constraints can be obtained by determining the effects of and on .
• The effect of tax evasion on firms’ financial constraints
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Using the implicit function theorem, from equation (8) we obtain that the effect of tax evasion on
the amount of screening is given by
C

E! ∗ =F , G@ ! !@H ! I ?J@H ! KF ,
= . (11)
E @HH ! 2!= , >?9A K , J:4
AC

10
It is useful to emphasize that, as in Zazzaro (2005), an equilibrium may not exist for any parameters
configuration as the feasibility constraint, ≥ ∗ , may not be always satisfied in equilibrium. In this respect,
notice that various parameters may have effects in opposing directions. For example, the effect of on the
equilibrium interest rate ∗ is generally ambiguous. The direct effect (that works through the second component
in the right-hand side of (8)) is negative; fewer resources that can be recovered by the bank in case of project
failure need to be compensated by an increase in the interest rate ∗ . However, lower also provides the
incentive to the bank to increase the level of screening ∗ in order to finance a larger share of good projects (that
are less likely to fail); this in turn reduces the equilibrium interest rate. On the other hand, when = 0, the
optimal level of screening ∗ is implicitly determined by the equation , = 8′ /98 − 8′ : and the
equilibrium interest rate is ∗ = 9 , + :/ 8 . Hence, after some manipulations, the feasibility
constraint can be written as ∗ = 1⁄98 − 8′ : < , a condition that is always satisfied if is large
enough. In general, as the equilibrium mix ( ∗ , ∗ ) does not depend on , there will always be a level of that
satisfies the feasibility constraint ≥ ∗ .

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The sign of , ∗⁄, corresponds to the one of the numerator of (11) since the denominator is
always positive (recall that 8CC < 0 from (10)). The numerator of (11) is generally ambiguous as
there are two components of opposite sign.11 The first component is negative and captures the fact that
higher tax evasion increases the marginal cost of screening, , > 0, which makes it optimal for
∗
the bank to reduce the investment in screening ; this in turn reduces the share of good entrepreneurs
financed so increasing financial constraints. The second component of (11) is positive and measures
the effect of tax evasion on the investment in screening due to the lower amount of resources

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recovered by the bank in case of project failure when the firm evades more taxes; as more tax evasion
reduces the amount of loan recovered, this induces the bank to invest more in screening to reduce the
number of financed projects failing, which in turn reduces financial constraints.

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While the sign of , ∗⁄, is generally ambiguous, we now try to find conditions ensuring that the
sign is definite. In this respect, it is useful to notice that the size of the second component of the

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numerator of , ∗ ⁄, in (11) is increasing in the amount of resources generated by unsuccessful
projects, and it tends to zero as approaches to zero. Therefore, from the numerator of (11), it is
immediate to verify that there exists a level of , call it N, such that , ∗ ⁄, < 0 for all < N, and
, ∗ ⁄, > 0 when > N, where
U
AN
=F , G@ ! !@H ! I
N≡ ?@H ! KF ,
. (12)

In other words, when the amount of resources that the bank can recover in case of failure is
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relatively small, the effect of higher tax evasion on increasing the cost of screening dominates the
effect generated by the reduction of the loan recovered, and it unambiguously generates a reduction of
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the banks’ screening effort, which in turn increases financial constraints. Given that is lower than 1,
whenever the threshold N ≥ 1, is always lower than N and , ∗ ⁄, is always negative.
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• The effect of the inefficiency of the legal system on firms’ financial constraints
The impact of a higher degree of inefficiency of the judicial system on screening is
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E! ∗ =O , G@ ! !@H ! I ?J@H ! KO ,
E
= @HH ! 2!= , >?9A K , J:4
. (13)

Similarly to the case just described, the sign of , ∗ ⁄, is generally ambiguous and it is the same
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of the sign of the numerator of the right-hand side of (13) since the denominator is always positive.
The mechanisms at work are also unchanged since , and * , have the same sign of
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respectively , and * , and, therefore, the same considerations apply. Also in this case, we
can establish the existence of a level of , that we denote as P, such that , ∗⁄, < 0 for all < P and
, ∗ ⁄, > 0 for all > P, where
=O , G@ ! !@H ! I
P≡ . (14)
?@H ! KO ,

Hence, we conclude that higher degrees of judicial inefficiency always reduce the amount of screening
in equilibrium, which in turn increases firms’ financial constraints, whenever < P.12

− 8C > 0, 8C
11
Recall that , > 0, 8 > 0 and * , < 0.
12 ∗⁄
Again, when P ≥ 1, , , will always be negative.

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• The joint effect of tax evasion and the inefficiency of the legal system on firms’ financial
constraints
Finally, in order to understand the joint impact of tax evasion and legal system inefficiency on
firms’ financial constraints we need to determine the sign of the derivative of , ∗⁄, with respect to
. From (11) we obtain that
E E! ∗ ⁄E Q∙S =FO , G@ ! !@H ! I ?J@H ! KFO , T U∙S @HH ! 9!=O , ?JKO , :T
= (15)
E QV

where Φ≡− , 98 − 8C :− 8C * , and Υ ≡ −8CC 9 , + 1−

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* , : are respectively the numerator and the denominator of , ∗ ⁄, reported in (11).
The expression in (15) has the same sign of the numerator and it is generally ambiguous.

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However, under the assumption that , =* , = 0, the first component of the numerator
is equal to zero and the second component will have the same sign of −Φ as the component in brace is
always positive. Now recall that , ∗ ⁄, has the same the sign of its numerator Φ and, therefore, it

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follows that
E E! ∗⁄E E! ∗
sign E
= −sign
E
. (16)

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This result implies that a definite sign of the expression in (15) can be obtained when the sign of
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, ∗ ⁄, is also definite. Hence, when < N, , ∗ ⁄, < 0 and, therefore, , , ∗ ⁄, ⁄, is positive.
This means that higher values of lead to higher values of , ∗ ⁄, ; as , ∗ ⁄, is negative this
corresponds to a lower size of , ∗ ⁄, in absolute value. In other words, higher degrees of inefficiency
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∗
of the legal system make the optimal screening investment , and therefore firms’ financial
constraints, less sensitive to the increase of tax evasion .
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The intuition for this result is the following. When the legal system is very inefficient, the
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screening technology is quite costly and the optimal amount of information produced by the bank is
limited. Hence, an increase in tax evasion that further worsen the efficiency of the screening
technology will have a small effect on the reduction of information gathered by the bank and, in turn, a
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small effect on the reduction in firms’ financial constraints. In other words, tax evasion and judicial
system inefficiency mitigate each other’s negative effect on credit constraints.
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The following proposition summarizes the comparative statics results described above.
Proposition 2. Higher levels of tax evasion and inefficiency of the legal system generally
AC

∗
have an ambiguous effect on the equilibrium screening effort and, therefore, on credit constraints.
When the income of the project in case of failure is relatively small, more tax evasion and lower
efficiency of the legal system both increase the level of screening, which reduces credit constraints. In
this case, tax evasion and legal system inefficiency mitigate each other’s negative effect on credit
constraints.

4. Model Specification and Data Description

Our empirical model assumes that the conditional probability of the firm being financially
constrained, Pr(CREDIT=1 | X), depends on a set of independent variables and a constant term as

13
follows:
ACCEPTED MANUSCRIPT
pij = Pr(CREDITij=1 | X) = Φ(X′β), (17)
where
X ′β = β 0 + β1TAXEVij + β 2 JUDSij + β 3TAXEVij * JUDSij + β 4′Z ij + β 5′C j + ε ij .

The indexes i and j refer to firms and countries respectively, Zij and Cj are vectors of
(respectively) firm-specific and country-specific variables, and the error term εij is assumed to be
independent and identically distributed. Φ = (·) is a cumulative distribution function (CDF), which is

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assumed to be, alternatively, a linear function or a Normal distribution, as discussed in the next
session.
We employ the World Bank’s data set Voices of the Firms 2000, which contains enterprise data

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based on a survey—of more than 10,000 firms in 80 countries—that was carried out between late 1999
and mid-2000 (Batra et al., 2002).

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Our dependent variable, CREDIT, is a binary indicator variable set equal to 1 if the firm is
financially constrained (and to 0 otherwise). In the data set, this variable is keyed to manager

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responses to the following question: How problematic are general financial constraints for the
operation and growth of your business? The managers’ assessments are reported on a 4-point scale: 1
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for “no obstacle”, 2 for “minor obstacle”, 3 for “moderate obstacle” and 4 for “major obstacle”. We
construct our dummy variable as indicating 1 for response values 3 or 4 and as indicating 0 for
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response values 1 and 2.13

Our explanation for why firms have difficulty accessing credit markets is based on two main
variables: tax evasion (TAXEV), which is measured as the percentage of sales not reported to tax
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authorities (so higher values correspond to less compliance),14 and the inefficiency of the judicial
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system (JUDS), which reflects observations made by the firms themselves (and where higher values
correspond to less efficiency, or more inefficiency).
The index of tax evasion we use is an audit-based measure of tax compliance and therefore it has
EP

the twofold advantage to reflect a direct evaluation of tax evasion and to allow homogenous
comparison across a large number of countries, which is particularly useful to address our research
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question. The downside of dealing with a self-reported measure of tax compliance is that it could yield
low reports of tax evasion and may suffer from selection bias and measurement errors.15 In order to
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overcome this shortcoming, we follow the approach suggested by Gatti and Honorati (2008), and we
compare the average country percentage of tax evasion, with other indirect measures of informality,
such as Elgin and Öztunali’s (2012) and Hassan and Schneider’s (2016) estimates of the shadow

13
Following Beck et al. (2004, 2006, 2008) and Gatti and Honorati (2008) our index of firms’ financial
constraints relies on a direct self-reported measure of financing obstacles.
14
Managers are asked to estimate the percentage of total sales that counterpart firms typically keep “off the
books”. The variable TAXEV is then assigned a value ranging from 1 to 7 based on these estimates, where 1 = no
evasion, 2 = 1–10% of total sales unreported, 3 = 11–20% unreported, 4 = 21–30%, 5 = 31–40%, 6 = 41–50%,
and 7 = more than 50% of total sales unreported.
15
It is also worth emphasizing that enterprises in African countries, where the data were obtained predominately
from mail surveys, rather than from in-person interviews, and reveal very low response rates and implausible
reports of tax compliance, are not included in our sample.

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 ACCEPTED MANUSCRIPT
economy for the 1999-2000.16 Simple cross-country correlations show a positive and statistically
significant (at 1 percent probability level) correlation between our variable of tax evasion and
Schneider’s (0.23) and Elgin’s (0.20) estimates of the shadow economy, as expected.17
In order to test the theoretical implications, we also employ an interaction term between these
two factors (TAXEV*JUDS); with this variable we mean to capture how much the main effect (i.e., of
tax evasion on reduced credit access) depends on the value of our conditioning variable (judicial
inefficiency).18
We also consider a country-varying measure of judicial inefficiency (CONFIDENCE) based on

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the World Bank’s Doing Business data set (World Bank, 2004; Djankov et al., 2007), to control for
country effects (if any) on the relation between legal system quality and the likelihood of firms facing

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credit access difficulties. This variable ranges from 1 to 6, where a higher score indicates more
confidence in the system.19

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Control variables include both firm- and country-specific characteristics. We consider different
measures related to firms’ financial structure that could, in principle, influence their ability to secure
external financing. In particular, we take into account the variation in past investment (PASTINV) to

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control for the firms’ profit opportunities. In addition, we consider the degree of a firm’s openness to
AN
foreign commerce by accounting for whether or not the firm exports (EXPORT) and for whether or not
the firm operates in other countries (FDI). We also account for the sector in which a firm operates
(MANUFACTURING, SERVICES, CONSTRUCTION, or AGRICULTURE) as well as for whether
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government firm ownership (STATE_OWNED) is present.

Berger and Udell (1998) analyze a life-cycle theory of firm financial models and argue that the
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firm’s optimal strategy is to use different sources of funding at different stages of its growth and
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development; we therefore control for both firm size and firm age. We add three dummy variables
based on the number of employees: SMALL, MEDIUM, and LARGE are set equal to 1 only if the firm
has (respectively) fewer than 50 employees, from 50 to 499 employees, and 500 or more employees.
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We also include a variable (AGE) that is equal to the number of years since the firm was founded. In
theory, small firms are more likely to suffer from informational opaqueness and asymmetric
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information problems; these factors should render small firms more finance constrained than large
firms. Similarly, AGE should be an important determinant of firms’ financial structure given that
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16
While Hassan and Schneider’s (2016) estimates of the shadow economy are based on a MIMIC approach and
refer to 157 countries over 1999 to 2013, Elgin’s (2015) measure builds on a two-sector dynamic general
equilibrium model and relies micro-foundations, so it is not based on econometric specifications, and it provides
a 161-country panel dataset over the period 1950-2009.
17
Obviously, we are dealing with different measures of informality, which reflect different concepts of the
phenomenon as well as different measurement methodologies. However, the positive correlation indicates that
there is a trend of complementarities among these indexes.
18
Multiplicative interaction models are common in the quantitative social and political science literature.
Institutional arguments frequently imply that the relationship between economic inputs and outcomes varies
depending on the institutional context (Brambor et al., 2006).
19
CONFIDENCE is correlated with alternative measures of legal system inefficiency. In particular, it is
positively correlated (+0.58) with RULEOFLAW, which captures the quality of police, courts, and contract
enforcement as well as the probability of crime and violence (Kaufmann et al., 2005); and it is also negatively
correlated (−0.33) with legal system inefficiency at the country level (JUDS_CL).

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 ACCEPTED MANUSCRIPT
younger firms usually find it harder than older firms to access capital markets. Because older firms
have had more time to establish their reputation, younger firms are considered to be riskier. To
account for a possible nonlinear impact of firm age, we also include the variable AGE2.
Our specification contains controls for country-specific characteristics that are related to
institutional quality and the extent of economic development. Again, we use information available in
the World Bank’s Doing Business data set (World Bank, 2004; Djankov et al., 2007). Specifically, we
employ the log of gross per capita national product in 1999 (LOG_GNP) to capture each country’s
extent of economic development and use the country’s average level of education (SCHOOL) to

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control for human capital.
As institutional variables, we follow both La Porta et al. (1999) and Glaeser and Shleifer (2003)

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in using dummies to identify the legal origin of each country’s “company law” or commercial code
(ENGLISH, FRENCH, GERMAN, SCANDINAVIAN, SOCIALIST). La Porta et al. show that a legal

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system’s origins, the content of its laws, and the quality of law enforcement all affect not only how
well creditors’ rights are protected but also how well capital markets perform. For example, countries
whose legal system is founded on common law (i.e., those whose legal origin is English) provide

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stronger protection for investors than do countries whose legal system is founded on civil law (i.e.,
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those of German, French, or Scandinavian origin).20
Furthermore, we control for the degree of ethnic fractionalization (ETHNIC). The motivation for
this control variable is that the empirical literature has demonstrated that a country’s ethnic
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fractionalization is linked to (i) its government’s level of economic intervention in the economy and
(ii) the levels of efficiency and corruption in public administrations (Mauro, 1995; Easterly and
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Levine, 1997; La Porta et al., 1999; Alesina et al., 2003). This variable is calculated as the probability
that two individuals chosen randomly from a population belong to different groups.21
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Finally, we control for other country-specific unobservable variables by means of country fixed
effects. The regression sample contains 4293 observations and covers 48 countries.22
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[ INSERT Table 1 about Here ]

Table 1 reports correlations among some variables of interest. It reveals that our proxies for
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judicial system inefficiency are positively correlated with each other and with tax evasion, and that all
correlations are statistically significant at 1% probability level. As expected, we observe a positive
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correlation between tax evasion and credit difficulties and between legal inefficiency and credit
constraints. The latter result holds irrespective of which measures are used to assess legal inefficiency.
[ INSERT Table 2 about Here ]
Table 2 gives some descriptive statistics, which are sorted by firm size in Table 3. Smaller firms

20
For a discussion of the effects of the quality of institutions on informality see Teobaldelli (2011) and
Teobaldelli and Schneider (2013) as well as the references cited therein.
21
Additional information on the variables used here are available upon request in an unpublished appendix.
22
As our model includes a full set of control variables, multicollinearity might be a concern, as it increases the
standard errors and reduces the precision of our estimates. Thus, by means of the variance inflation factor (vif)
we also select a more parsimonious specification and estimate again Model (17). Estimates confirm the paper
findings, and are available upon request by the authors.

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 ACCEPTED MANUSCRIPT
experience higher levels of tax evasion, as the mean level of tax evasion among small firms is higher
than that of both medium- and large-sized firms, and those mean differences are statistically
significant at 1% probability level. At the same time, small and medium-sized firms have more
difficulty accessing credit than do large firms.

[ INSERT Table 3 about Here ]

To empirically verify the hypotheses H1 and H2 we expect the estimated coefficients of β1 and β2
to be positive, i.e.: the higher the level of tax evasion or the legal system inefficiency, the higher the

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probability of firms being credit constrained. Further, according to the hypothesis H3, we also expect a
negative (positive) estimated coefficient of β3, if tax evasion and legal system inefficiency mitigate

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(reinforce) each other’s negative effect on firm financing constraints.

5. Empirical Strategy and Discussion of Results

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The empirical Model (17) assumes that the probability of a firm to be financially constrained depends
on tax evasion, the inefficiency of the legal system and on their interaction, plus a set of control

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variables. The empirical strategy is to estimate Model (17) by using alternative techniques.
We first assume a Linear Probability Model (LPM), according to which the dichotomous
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CREDIT variable is a linear function of the independent variables X. In large samples, the statistical
inference of the LPM follows the OLS procedures under the normality assumption. The LPM is
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attractive because the slope coefficient measures directly the change in the probability of being
financially constrained (CREDIT=1) as a result of a unit change in the value of a regressor. Further,
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OLS estimates are efficient, that is they have minimum variance. However, there is a major problem
with the OLS estimation of the LPM, i.e. the estimated coefficients do not necessarily lie between the
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[0,1] range. Therefore, we in turn show the estimated coefficients of Model (17) obtained by a Probit
estimation. The Probit model has two features: (i) as X increases the probability increases but never
steps outside the [0,1] range; and (ii) the relationship between the probability of being financially
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constrained and the vector of variates X is nonlinear.

5.1. Linear Probability Model

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Column 1 of Table 4 reports OLS estimates of a benchmark specification of equation (17) in which are
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included only the main variables of interests, assumed to be exogenous.23 As hypothesized, the results
indicate that both tax evasion and legal inefficiency are important determinants of the firms’ financing
constraints: the higher the level of tax evasion, the greater the probability that firms’ access to finance
will be constrained (β1 = 0.037, i.e. the probability of being financially constrained increases of 3.7%
as TAXEV increases of a unit). Thus an inefficient legal system reduces the capacity of firms to borrow
from the financial market. The firm’s likelihood of encountering credit constraints is increasing in the
legal system’s inefficiency (β2 = 0.080). Both coefficients are statistically significant at the 1% level.

[ INSERT Table 4 about Here ]

23
Standard errors are clustered at the country level.

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Our focus is on the joint significance of these two terms—specifically, on the marginal effect of
each one on the dependent variable. The coefficient for the interaction term is negative and statistically
significant (β3 = −0.008). Including an interaction term implies that the coefficient β1 (resp. β2)
captures the effect of tax evasion (resp. judicial inefficiency) on credit constraints only when judicial
inefficiency (resp. tax evasion) is equal to zero. Hence, our interest now is to investigate the marginal
effect of tax evasion on credit constraints; this effect will depend on the sign and magnitude of the
coefficients β1 (for tax evasion) and β2 (for judicial inefficiency) as well as on the coefficient β3 for the
interaction term. The marginal effect of tax evasion, ∆TAXEV, on the extent of credit constraints can

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now be expressed as ∆CREDIT = (β1 + β3 JUDS)∆TAXEV. Thus, we calculate the marginal effects by
deriving equation (17) first with respect to the tax evasion variable and next with respect to the

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judicial inefficiency indicator. Then we run the following F-test:

H 0 :β1 + β 3 JUDS = 0, (18)

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H 0 :β 2 + β3 TAXEV = 0, (19)

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where JUDS and TAXEV are the sample mean values of JUDS and TAXEV, respectively. The F-
test results (not reported) of both (18) and (19) reject the null hypothesis in favor of a negative effect
AN
of both variables on firms’ financial constraints.
These results suggest that tax evasion and judicial inefficiency attenuate each other’s negative
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effect on credit constraints. Indeed, estimates show that the marginal impact of tax evasion on
financial constraints decreases (the marginal effect of TAXEV*JUDS is equal to −0.8%) when the
judicial system is less efficient.
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Furthermore, the higher is judicial efficiency at the country level (measured by CONFIDENCE),
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the lower is the probability that firms will face difficulties in their access to credit (the marginal effect
of CONFIDENCE is equal to −15.5%). This result reinforces our previous finding about the effect of
judicial inefficiency as perceived by all firms (JUDS). Legal systems that are more efficient offer
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better investor protection, more enforceable property rights, and lower transaction costs. This explains
why, in the presence of more efficient judicial systems, capital markets are more developed and firms
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find cheaper sources of external finance.24

Column 2 of Table 4 shows estimates of the full equation (17). The control variables allow us to
AC

make the following generalizations. First, firms that operate in other countries (FDI) are less likely to
encounter problems when seeking to access credit. Second, both small firms (SMALL) and medium-
sized firms (MEDIUM) tend to be more credit constrained than large firms. Third, older firms (AGE)
seem to be less financially constraints than younger firms.

24
It could be argued that JUDS and CONFIDENCE in the regression might be collinear. Thus, we also check for
this possibility in our data by means of the collin command in Stata. The condition number, which is a
commonly used index of the global instability of the regression coefficients, turns out to be equal to 14. An
informal rule of thumb is that if the condition number is 15, multicollinearity is a concern; if it is greater than 30,
multicollinearity is a very serious concern. For robustness, we also estimate Model (17) dropping
CONFIDENCE from the set of the independent variables. Estimates confirm the paper findings, and are
available upon request by the authors. See also Footnote 22.

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5.2. Probit Model
The linear probability model is a useful benchmark, although it may have problems obtaining
estimated coefficients (and, thus, expected probabilities) that lie outside the [0,1] range. It is limited
also in presupposing that the conditional probability of being financially constrained is linearly
increasing in the vector X of variates. Columns 3 and 4 of Table 4 give Probit estimates of equation
(17); in this model, as mentioned previously, Φ = (·) is the normal CDF.
The estimates confirm our previous findings. Tax evasion increases the likelihood of being credit
constrained. The marginal effect of TAXEV (not tabulated) is equal to 1.9% and 1.5% in columns 3

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and 4, respectively. Similarly, the less efficient the legal system, the harder it is for firms to secure
credit. Specifically, the probability of being financially constrained increases of 5.7% as JUDS

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registers a unit increase (marginal effect not tabulated). Our estimated coefficient for the interaction
term (TAXEV*JUDS) is negative, which confirms that tax evasion and judicial inefficiency attenuate

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each other’s negative effect on credit constraints. As the magnitude of the interaction effect in
nonlinear models does not equal the marginal effect of the interaction term, marginal effects of the
interaction variables are computed following Ai and Norton (2003) and reported in Table 5.25

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[INSERT Table 5 about Here ]
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Table 5 shows that the probability of being credit constrained increases with the level of tax
evasion. Furthermore, it shows that the impact of tax evasion on firm financial constraints depends on
the efficiency of the legal system. Indeed, the marginal effect of tax evasion is higher in the presence
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of more efficient legal systems (JUDS=1 in Table 5), i.e. when the legal system efficiently ensures the
enforcement of property rights and contracts, by choosing the informal sector firms forgo to rely on
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key public goods, such as contract enforcement and proper information flows, that would facilitate
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access to credit. Meanwhile, when the legal system is highly inefficient (JUDS=4 in Table 5), this
trade off vanishes and tax evasion does no more negatively affect firm access to credit. As discussed,
this finding suggests that the effects of tax compliance and judicial inefficiency on firms’ credit
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constraints mitigate each other. Operating in the informal sector might not affect firm credit access if
the legal system cannot efficiently ensure the enforcement of property rights and contracts.
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5.3. Instrumental Variables Estimation

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Within the literature that analyzes the possible mechanisms underlying a link between informality and
access to credit, this paper is part of the strand that views a firm’s limited ability to borrow from the
official banking system as a consequence of operating informally (Dabla-Norris and Feltenstein, 2005;
Gatti and Honorati, 2008). However, it could be argued that less productive firms, which find it
difficult to obtain financing, have an incentive not to fully comply and in that way self-finance their
activity. Our estimates could then suffer from endogeneity bias due to reverse causality. Furthermore,
it could also be the case that unobservable variables affect both firm’s perception of the efficiency of
the legal system and its ability to leverage, generating a triangular system (Baltagi, 2002). In these

25
We used the Stata 11 margins command to calculate the marginal effects of the interaction variables.

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cases, the OLS- and Probit-estimated coefficients (reported in Table 4) are biased. However, while the
endogeneity problem for informality is serious, the potential threat from omitted variable bias related
to the efficiency of the legal system are much less important in our opinion.
To address these problems, we rely on instrumental variables (IV) techniques and estimate
Model (17) allowing both TAXEV and JUDS to be endogenously determined. In developing the IV
analysis, we employ three instruments: corruption, availability of laws and regulations, and tax
administration burden.
As instruments for tax evasion, we use a measure of how firms perceive that the information on

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the laws and regulations is easy to obtain (AV_REG) and an index that captures how firms perceive the
tax administration regulatory area to be problematic (TAX_REG). The rationale for using these two

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variables relies on the empirical findings (Schneider and Neck, 1993; Johnson et al., 1997; Johnson et
al., 1998) that the density and complexity of the tax system and the burden of regulation, as well as the

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ineffective application of the tax system by government, are important factors influencing the shadow
economy and play a big role in the bargaining game between the government and the taxpayers, as
they alter individuals’ decision to operate informally.

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The other instrument employed is a variable that quantifies how much corruption of bureaucracy
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affects firm activity (G_CORR). We expect this variable to be a good instrument for both informality
(TAXEV) and the inefficiency of the judicial system (JUDS). Indeed, a number of works have
emphasized the negative correlation between informality and different aspects of the quality of
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institutions, including corruption. For example, various authors (Johnson et al., 1998; Friedman et al.,
2000; Dutta et al., 2013; Dell’Anno and Teobaldelli, 2015) find evidence that countries with more
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corruption are ones in which the unofficial economy is more predominant; these authors conclude that
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going underground and corruption are linked by a complementary relationship. The effects of
corruption on the official economy can be considered as a tax on profits that provides an incentive to
operate informally in order to avoid it. At the same time, the literature has emphasized a positive
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correlation between corruption and the inefficiency of the judicial system (Shleifer and Vishny, 1993;
Svensson, 2005).26 Thus, we expect that increasing values of G_CORR are associated with higher level
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of both TAXEV and JUDS.

Yet for all these variables to be good instruments, they must be uncorrelated with the error term
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of the estimated equation of our outcome variable CREDIT. We do not see reasons for all these three
variables having a direct effect on the variable CREDIT except through their effect on the
instrumented variables, also because in our estimated equations we always control for country fixed
effects, which are likely to capture many unobservable factors.27

26
Corruption undermines the rule of law and causes judicial system dysfunction by undercutting the application
of the law and preventing the development of effective legal frameworks. At the same time, when judicial
systems are more inefficient, corruption proves to be more widespread.
27
Two out of the three instruments we use—our measure of corruption (G_CORR) and the measure of
transparency on laws and regulations (AV_REG)—might raise some concerns. Particularly, the critique might
refer to the wide spread practice in many countries that bank officials seek rents in exchange for granting loan
applications. Given these common practices, there might be a suspect that the two instruments are correlated

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The estimated results of the IV analysis are reported in Table 6.
[ INSERT Table 6 about Here ]
In column 1 of Table 6 we estimate a linear probability model via a two-stage least-squares
(2SLS) regression. In the first stage, we run OLS regressions of TAXEV and JUDS on all covariates
included in equation (17) and on the three above-mentioned instruments. In the second stage, we
estimate equation (17) as a standard linear probability model while adding the estimated residuals of
the first-stage OLS regressions. This two-stage procedure has the advantage of allowing for a simple
test (the Durbin score) of the exogeneity of TAXEV and JUDS. The test statistics reject the null

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hypothesis of exogenous TAXEV, while fails to reject the null of exogenous JUDS (p = 0.22).
Therefore, in columns 2−7 of Table 6 we treat the inefficiency of legal system as exogenous

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regressor. Columns 2−4 show estimation results of Model (17) in which TAXEV is assumed to be the
only endogenous variable.

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For the IV estimator to obtain its ideal properties, the instruments must satisfy two conditions.
An instrumental variable must be uncorrelated with the error term and strongly correlated with the
endogenous variable (after the other independent variables are controlled for). We use the

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overidentified restrictions to test for instrument validity via a Sargan test (the first condition, labeled
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“Overid Test” in Table 6). This procedure assumes that one instrument is valid and then tests the
validity of all other instruments—that is, it tests for whether the instruments are uncorrelated with the
error term in the second stage. The values we derive for the Sargan statistic do not allow us to reject
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the null hypothesis of overidentification; this demonstrates that the instruments are significantly
correlated with the endogenous variable but not with the difficulties of credit access. The second
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condition is related to the so-called weak identification problem, which arises when the excluded
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instruments are correlated with the endogenous regressors but only weakly so. If the instruments are
weak (and thus of limited relevance) then the IV estimator will not possess its ideal properties and
could report misleading results. Column 2 of Table 6 shows that the F-statistic computed for the weak
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identification test is lower than the critical value of 10 (Stock and Yogo, 2005), suggesting that we
might be in the presence of weak instruments. Thus, column 3 shows estimation results by means of
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the LIML estimator, which has better small sample properties than 2SLS with weak instruments. It is a
linear combination of the OLS and 2SLS estimate (with the weights depending on the data), and the
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weights are such that they (approximately) eliminate the 2SLS bias (Bound et al., 1996).28 Finally,
column 4 shows IVPROBIT estimation results.
Nevertheless, the first stage results are consistent with the rationale for our instruments. Higher

with the error term. Fortunately, as discussed in the paper, the Sargan test offers reassuring results. Furthermore,
we also estimate Model (17) using as single instrument TAX_REG, and estimate results are overall confirmed
(see also Footnote 28). Finally, for robustness purposes, we explicitly control for the corruption of bank officials
in Model (17). While the sample size reduces to 3,603 observations, the variable corruption of bank officials is
never statistically significant. Estimates are available upon request by the authors.
28
The redundancy instrument test at the bottom of Table 6 fails to reject the null hypothesis of redundancy only
for the instrument AV_LAW. For robustness, as just-identified IV is approximately median-unbiased, we also
estimated Model (17) by means of 2SLS and using as single instrument alternatively AV_LAW, G_CORR and
TAX_REG. Estimates results are overall confirmed and available upon request by the authors.

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 ACCEPTED MANUSCRIPT
corruption (G_CORR), higher difficulties in law availability (AV_LAW) and higher regulation in tax
administration (TAX_REG) are positively correlated with higher level of tax evasion, although not
always statistically significant.
Finally, columns 5−7 of Table 6 show estimation results of Model (17) in which we also treat as
endogenous variable the interaction term TAXEV*JUDS. Based on previous results, in these columns,
we restrict the set of instruments to G_CORR and AV_LAW. We then instrument the interaction term
TAXEV*JUDS with the interaction G_CORR*JUDS (Wooldridge, 2002, pp. 121−122; Bun and
Harrison, 2014). Firstly, we note from the Endogeneity Test reported at the bottom of Table 6 that the

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null of exogeneity is rejected and the interaction term TAXEV*JUDS is in fact endogenous.
Secondly, the first stage results of columns 5−7 show that, consistent with the rationale for our

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instruments, higher corruption and higher obstacles in law availability lead to higher tax evasion.
Further, both the interacted instrument G_CORR*JUDS and AV_LAW are positively and significantly

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correlated with TAX_EV *JUDS.
Diagnostics tests offer reassuring results. The statistic of the F-test is 13.53 and indicates that our
instruments are relevant and so robust inferences can be drawn from our estimates. With regard to the

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exclusion restriction, the Overid Test indicates that we cannot reject the null hypothesis that our
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instruments are uncorrelated with the error term.
Overall, the estimated coefficients of columns 5 and 6 of Table 6 show that the impact of tax
evasion on the probability of the firm of being financially constrained is positive and statistically
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significant at the 1% level, and its magnitude becomes larger in absolute value than the corresponding
estimated coefficients of Table 4, suggesting that the endogeneity of TAXEV might undervalue its
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impact on credit constraints if not accounted for. Thus legal system inefficiency (JUDS) has a
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marginal effect of about 16% on the probability of the firm being financially constrained, while the
interaction between tax evasion and legal system inefficiency (TAXEV*JUDS) reduces the same
probability by about −5%. Therefore, tax evasion and the inefficiency of the legal system continue to
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reduce each other’s negative effect on firm difficulties of credit access. Further, confirming the
findings of Table 4, TAXEV and JUDS are still detrimental to firm access to credit once we take into
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account their interaction effect (not reported).

Similarly, column 7 of Table 4 shows the IVPROBIT estimates for equation (17). Here Newey’s
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efficient two-step estimator was used to derive the coefficient estimates.29

The results from this two-step procedure confirm and reinforce our previous findings: tax
evasion and judicial inefficiency are significantly associated with the financial constraints faced by
firms; moreover, the association between tax evasion and financial constraints declines as the legal
system becomes less efficient. Although one could reasonably anticipate an endogeneity problem, the
resulting bias in the OLS and Probit coefficients is not significant.

5.4. Robustness Checks

29
Unfortunately, Newey’s efficient two-step estimation technique does not allow to compute the marginal
effects of independent variables.

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To check the robustness of our results, Table 7 shows estimation results of Model (17) while using an
alternative measure (COURT) of judicial inefficiency that captures the quality of courts as perceived
by firms. It takes values from 1 to 6, and higher values are associated with lower quality of the legal
system. Overall, estimates show that tax evasion and low-quality legal systems are obstacles to credit
access because both increase the likelihood that a firm will be credit constrained. The estimated
coefficient for the variable TAXEV*COURT, which is intended to capture the interaction between tax
evasion and perceived low quality of the legal system, is negative and statistically significant in
columns 1 to 5, while not statistically significant in columns 6 and 7. The marginal effect of tax

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evasion on firm financing constraints depends on the level of the court quality, as reported in Table 5.
Thus, as with the previous regressions, a low-quality legal system mitigates the effect of a firm’s tax

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evasion on its financial constraints.
[ INSERT Table 7 about Here ]

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Finally, we rerun the Probit analysis by firm size in order to assess how this factor influences the
effects of tax evasion and judicial quality on firms’ financial constraints. Indeed, the descriptive
statistics alone are sufficient to establish that tax evasion varies as a function of size; as mentioned

U
previously, small firms are more likely to evade taxes. They also suffer more (than do other firms)
AN
from financial constraints; see Table 2.30 Hence we display in Table 8 the estimated coefficients for
Model (17), by firm size, while assuming first that both TAXEV and TAXEV*JUDS are exogenous and
then that both are endogenous. The resulting estimates confirm our previous findings about the
M

detrimental impact of TAXEV and JUDS on the credit access of small and medium-sized firms. As for
the joint significance of these two variables, we find that the coefficient for their interaction term is
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neither negative nor statistically significant except in columns 1 and 4 of Table 8, so again the
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marginal effect of tax evasion on firms’ financial constraints declines with decreasing efficiency of the
judicial system.
[ INSERT Table 8 about Here ]
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6. Summary and Policy Conclusions

C

Previous studies have pointed out that, on the one hand, a firm’s ability to raise external finance is
positively associated with greater tax compliance and, on the other hand, credit markets develop in
AC

concert with improvements in the ability of legal institutions to protect private credit.
We improved on the existing literature by analyzing theoretically and empirically the joint
impact of tax evasion and legal system inefficiency on firm financial constraints. Our theoretical
analysis highlights that generally tax evasion and inefficiency of the legal system may have both
positive and negative effects on the ability of the firms to obtain credit. However, we provide
conditions under which higher levels of tax evasion and legal system inefficiency increase the firms’

30
Beck and Demirguc-Kunt (2006) discuss the relevance of access to finance for SMEs growth, and the role of
financial and legal institutions in relaxing SMEs financing constraints.

23
 ACCEPTED MANUSCRIPT
financing constraints. Our model also suggests that tax evasion and legal system inefficiency might
mitigate each other’s negative effect on credit constraints.
By using firm-level, cross-country data from Voices of the Firms 2000 based on the World
Business Environment Survey, our empirical findings confirm that the probability of firm of being
financially constrained substantially increases as long as tax evasion and the inefficiency of the legal
system increases. Moreover, the empirical analysis shows that the impact of tax evasion on firms’
financial constraints is lower when the inefficiency of the judicial system is higher.
Our findings suggest that quality government institutions—in particular, an efficient judicial

PT
system—are essential for the development of effective financial institutions and especially so in the
context of widespread unofficial economic activity. Moreover, as explained in the Introduction, the

RI
fact that tax evasion and the inefficiency of the legal system mitigate each other in affecting firms’
financial constraints implies that the adoption of policies improving the firms’ access to finance are

SC
more likely to be implemented when the government can act along both dimensions. When instead
only one kind of policy, i.e. the reduction of tax evasion or the improvement of the legal system, is
available, the incentives for policy reforms are lower because of their limited effects. However, such

U
incentives eventually increase once exogenous shocks or the adoption of virtuous policies in the other
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area take place.

Acknowledgements
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This paper benefited from comments and suggestions from two anonymous referees and participants at
the 2012 annual meeting of the Italian Association of Public Economics and the 2015 annual meeting
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of the Italian Economic Association. We are especially grateful to Giorgio Calcagnini, Roberto
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Dell’Anno, Giorgia Maffini, Davide Ticchi, and Alberto Zazzaro for discussions and suggestions. The
usual disclaimers apply. This research did not receive any specific grant from funding agencies in the
public, commercial, or not-for-profit sectors.
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AC

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Table 1. Correlation matrix of the main variables of interest

(1) (2) (3) (4)

(1) Constraints to Credit Access 1.00

(2) Tax Evasion 0.15*** 1.00

(3) Inefficiency of Legal System 0.17*** 0.11*** 1.00

(4) Confidence in the Legal System −0.20*** −0.11*** −0.15*** 1.00

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Notes: The table presents the correlation matrix for the Constraints to Credit Access (CREDIT), Tax Evasion
(TAXEV), Inefficiency of Legal System (JUDS), and Confidence in the Legal System (CONFIDENCE).
Definition and construction of each variable is provided in the Data Appendix. The sample consists of 4,293

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observations. Source: Voices of the Firms 2000, World Business Environment Survey. *** p<0.01, ** p<0.05, *
p<0.1

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Table 2. Descriptive statistics of the regression sample

U Mean Std. Dev. Median Min Max

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VARIABLES
DEPENDENT VARIABLE
Constraints to Credit Access 0.62 0.49 1 0 1
MAIN INDEPENDENT VARIABLES
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Tax Evasion 2.8 2.1 2 1 7

Inefficiency of Legal System 2.15 1.03 2 1 4
Quality of Legal System 3.22 1.38 3 1 6
Confidence in the Legal System 3.68 0.65 3.84 2.62 5.41
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CONTROLS
Past Investment 1.37 0.48 1 1 2
Firm Age 22.1 25.04 12 1 427
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Export 0.36 0.48 0 0 1

FDI 0.19 0.39 0 0 1
Government 0.12 0.32 0 0 1
Log_gnp 8.14 1.09 8.13 5.91 10.37
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Educ 7.72 2.38 7.62 2.45 12.25

Ethnic 0.37 0.19 0.32 0.05 0.74
Notes: The table presents the summary statistics for the sample used in the multivariate analysis. Definition and
construction of each variable is provided in the Data Appendix. The sample consists of 4,293 observations.
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Source: Voices of the Firms 2000, World Business Environment Survey.

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Table 3. Descriptive statistics of the main variables by firm-size category

Constraints to Credit Access

Statistics Mean differences (column - row)
Obs. Mean Std. Dev. Small Medium Large

Small 1525 0.67 0.47 0.04*** 0.16***

Medium 1922 0.63 0.48 -0.04*** 0.12***

Large 844 0.51 0.50 -0.16*** -0.12***

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Tax Evasion
Statistics Mean differences (column - row)

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Obs. Mean Std. Dev. Small Medium Large

Small 1525 3.17 2.16 0.47*** 0.84***

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Medium 1922 2.70 2.04 -0.47*** 0.37***

-0.84*** -0.37***

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Large 844 2.33 1.98
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Inefficiency of Legal System
Statistics Mean differences (column - row)
Obs. Mean Std. Dev. Small Medium Large
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Small 1525 2.08 1.05 -0.10*** -0.13***

Medium 1922 2.18 1.03 0.10*** -0.04

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Large 844 2.21 1.00 0.13*** 0.04

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Source: Voices of the Firms 2000, World Business Environment Survey. *** p<0.01, ** p<0.05, * p<0.1
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Table 4. Financial Constraints, Tax Evasion and the Inefficiency of Legal Systems

LINEAR PROBABILITY MODEL PROBIT MODEL

Dependent variable (1) (2) (3) (4)
CREDIT

TAXEV 0.037*** 0.038*** 0.102*** 0.097***

(0.008) (0.008) (0.024) (0.022)
JUDS 0.080*** 0.089*** 0.229*** 0.242***
(0.014) (0.014) (0.042) (0.041)
TAXEV*JUDS -0.008** -0.010*** -0.022** -0.024**
(0.003) (0.003) (0.011) (0.010)

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CONFIDENCE -0.154*** -0.125*** -0.373*** -2.157***
(0.006) (0.005) (0.019) (0.430)
PASTINV 0.012 0.026
(0.018) (0.054)
EXPORT 0.014 0.065

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(0.023) (0.069)
FDI -0.055** -0.158**
(0.022) (0.063)
SMALL 0.108*** 0.333***

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(0.030) (0.087)
MEDIUM 0.073*** 0.225***
(0.019) (0.054)
AGE -0.002* -0.005***

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(0.001) (0.002)
AGE2 0.000 0.000***
(0.000) (0.000)
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MANUFACTURING -0.005 -0.019
(0.029) (0.092)
SERVICES -0.083** -0.257**
(0.032) (0.104)
CONSTRUCTION 0.064* 0.192
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(0.038) (0.120)
PUBLIC_OWNED 0.061*** 0.177**
(0.022) (0.073)
LOG_GNP -0.075*** 0.030
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(0.003) (0.171)
EDU 0.062*** -0.132
(0.002) (0.113)
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ETHNIC 0.818*** 3.224***

(0.018) (0.649)
CONSTANT 0.985*** 0.555*** 1.117*** 8.746***
(0.054) (0.101) (0.142) (1.319)
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COUNTRY FIXED EFFECTS YES YES YES YES

LEGAL ORIGIN YES YES YES YES

OBSERVATIONS 4,293 4,293 4,293 4,293

R SQUARED 0.152 0.173 - -
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Notes: The table presents multivariate analysis of Model (17), i.e. the impact of tax evasion (TAXEV), legal
system inefficiency (JUDS) and their interaction (TAXEV*JUDS) on firm financing constraints (CREDIT).
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Column 1 assumes a Linear Probability Model and shows OLS results of reduced version of Model (17), while
column 2 shows results of the full model specification. Columns 3 and 4 assume a Probit Model. Standard errors
clustered at country level are in parentheses. *** p<0.01, ** p<0.05, * p<0.1

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Table 5. The marginal impact of tax evasion on firm financing constraints
Legal system Marginal effect Standard error Z p-value
Legal system efficiency
High (JUDS=1) 2.48% 0.004 5.58 0.000
Medium (JUDS=2) 1.59% 0.003 5.32 0.000
Low(JUDS=3) 0.76% 0.005 1.66 0.097
Very Low (JUDS=4) -0.03% 0.006 -0.04 0.967
Legal system quality
Very High (COURT=1) 2.97% 0.006 5.07 0.000
High (COURT=2) 2.37% 0.004 5.54 0.000

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Medium (COURT=3) 1.71% 0.003 5.38 0.000
Medium Low(COURT=4) 1.03% 0.003 3.15 0.002
Low(COURT=5) 0.46% 0.004 1.04 0.297
Very Low(COURT=6) -0.07% 0.006 -0.11 0.911

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Notes: This table shows the marginal effects of TAXEV on CREDIT as a function of the efficiency of legal
system (Top) and of the quality of legal system (Bottom). Marginal effects according to “Legal system
efficiency” (JUDS) are calculated according to Ai and Norton (2003) and refer to the interaction term

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TAXEV*JUDS of the Probit estimates of Model (17) reported in column 4 of Table 4. Marginal effects according
to “Legal system quality” (COURT) are calculated according to Ai and Norton (2003) and refer to the interaction
term TAXEV*COURT of the Probit estimates of Model (17) reported in column 2 of Table 7.

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Table 6. Alternative IV estimates of Tax Evasion, the Inefficiency of Legal Systems and their
interaction on Firm financial constraints
(1) (2) (3) (4) (5) (6) (7)
IV: Taxev Juds IV: Taxev IV: Taxev Taxev*Juds
VARIABLES 2SLS 2SLS LIML IVPROBIT 2SLS LIML IVPROBIT

TAXEV 0.903** 1.380*** 1.805*** 4.256*** 0.443*** 0.451*** 1.338***

(0.399) (0.410) (0.691) (1.206) (0.095) (0.098) (0.277)
JUDS 1.035*** 1.411*** 1.829*** 4.356*** 0.161* 0.159* 0.455
(0.358) (0.404) (0.681) (1.190) (0.086) (0.088) (0.279)
TAXEV*JUDS -0.326** -0.487*** -0.638*** -1.503*** -0.051* -0.051* -0.145
(0.138) (0.146) (0.246) (0.428) (0.030) (0.031) (0.096)

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Country FE yes yes yes Yes yes yes yes
Legal Origin FE yes yes yes Yes yes yes yes
Firm Controls yes yes yes Yes yes yes yes
Observations 4,084 4,084 4,084 4,084 4,116 4,116 4,116

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Instruments –first stage results
TAXEV
G_CORR -0.318*** 0.027 0.027 0.027* 0.217*** 0.217*** 0.217***
(0.021) (0.017) (0.017) (0.016) (0.070) (0.070) (0.066)

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AV_LAW 0.0001 0.023** 0.023** 0.023** 0.067*** 0.067*** 0.067***
(0.014) (0.011) (0.011) (0.010) (0.024) (0.024) (0.022)
TAX_REG -0.018 0.025 0.025 0.025*
(0.020) (0.016) (0.016) (0.014)
G_CORR*JUDS -0.013 -0.013 -0.013

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(0.027) (0.027) (0.027)
JUDS
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G_CORR 0.344***
(0.014)
AV_LAW 0.023**
(0.009)
TAX_REG 0.043***
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(0.012)
TAXEV*JUDS
G_CORR -0.202 -0.202 -0.202
(0.152) (0.152) (0.167)
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AV_LAW 0.118* 0.118* 0.118**

(0.062) (0.062) (0.057)
G_CORR*JUDS 0.311*** 0.311*** 0.311***
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(0.081) (0.081) (0.068)

Diagnostics
F-test 1st Stage 2.45 4.63 4.63 4.63 13.53 13.53 13.53
Overid Test (p value) 0.03 0.16 0.32 0.13 0.31 0.32 0.33
Redundancy Test - H0: Instrument is redundant (p-value)
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G_CORR 0.11 0.00

AV_LAW 0.03 0.01
TAX_REG 0.10 -
G_CORR*JUDS - 0.00
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Endogeneity Test - H0: regressor is exogenous (p-value)

TAXEV 0.00 0.00 0.00 0.00 0.00 0.00 0.00
JUDS 0.22
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TAXEV*JUDS 0.00 0.00 0.00

Notes: The table presents multivariate analysis of Model (17), i.e. the impact of tax evasion (TAXEV), legal system efficiency
(JUDS) and their interaction (TAXEV*JUDS) on firm financing constraints (CREDIT). The estimations include the full set of
controls used in Tables 4 but the coefficients are not reported. Description of the variables used in the analysis is provided in
the Appendix. Column 1 assumes TAXEV and JUDS as endogenous regressors, and show results of a 2SLS estimation.
Columns 2 to 4 treat TAXEV endogenous regressor and show results of a 2SLS, LIML and IV Probit models, respectively.
Columns 5 to 7 assume also TAXEV*JUDS as endogenous regressor and show results of a 2SLS, LIML and IV Probit
models, respectively. Instrument validity (overidentifying restrictions) is tested by Hansen J test in columns 1 to 3 and 5-6
and Amemiya-Lee-Newey minimum chi-sq test in columns 4 and 7, respectively. Robust standard errors in parentheses. ***
p<0.01, ** p<0.05, * p<0.1

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Table 7. Financial Constraints, Tax Evasion and the Quality of Legal Systems
(1) (2) (3) (4) (5) (6) (7) (8)
IV: Taxev IV: Taxev Taxev*Court
VARIABLES OLS Probit 2SLS LIML IVProbit 2SLS LIML IVProbit

TAXEV 0.036*** 0.103*** 1.473*** 1.616*** 4.557*** 0.305*** 0.306*** 0.869***

(0.008) (0.023) (0.327) (0.390) (0.981) (0.093) (0.094) (0.288)
COURT 0.037*** 0.103*** 1.040*** 1.140*** 3.216*** -0.076 -0.079 -0.307
(0.009) (0.028) (0.228) (0.273) (0.688) (0.093) (0.094) (0.270)
TAXEV*COURT -0.006*** -0.018*** -0.368*** -0.404*** -1.140*** 0.023 0.024 0.094
(0.002) (0.007) (0.082) (0.099) (0.247) (0.032) (0.032) (0.092)
Country FE yes yes yes yes yes yes yes Yes
Legal Origin FE yes yes yes yes yes yes yes Yes

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Firm Controls yes yes yes yes yes yes yes Yes
Observations 4,250 4,250 4,046 4,046 4,046 4,046 4,046 4,046
Instruments –first stage results
TAXEV

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G_CORR 0.056*** 0.056*** 0.056*** 0.318*** 0.318*** 0.311***
(0.013) (0.013) (0.013) (0.072) (0.072) (0.069)
AV_LAW 0.005 0.005 0.005 0.058** 0.058** 0.053**
(0.010) (0.010) (0.010) (0.024) (0.024) (0.023)

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TAX_REG 0.018 0.018 0.018
(0.014) (0.014) (0.014)
G_CORR*COURT -0.037* -0.037* -0.034*
(0.020) (0.020) (0.019)
TAXEV*COURT

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G_CORR -0.029 -0.029 -0.057
(0.232) (0.232) (0.250)
AV_LAW 0.199** 0.199** 0.184**
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(0.094) (0.094) (0.084)
G_CORR*COURT 0.177** 0.177** 0.189***
(0.083) (0.083) (0.069)
Diagnostics
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F-test 1st Stage 8.03 8.03 13.38 13.38

Overid Test (p value) 0.36 0.42 0.32 0.50 0.45 0.50
Notes: The table presents multivariate analysis of Model (17), i.e. the impact of tax evasion (TAXEV), legal system
quality (COURT) and their interaction (TAXEV*COURT) on firm financing constraints (CREDIT). The estimations
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include the full set of controls used in Tables 4 but the coefficients are not reported. Description of the variables used in
the analysis is provided in the Appendix. Column 1 assumes a Linear Probability Model and shows OLS results of
Model (17). Column 2 shows results of a PROBIT model. Columns 3 to 5 treat TAXEV endogenous regressor and show
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results of a 2SLS, LIML and IV Probit models, respectively. Columns 6 to 8 assume also TAXEV*COURT as
endogenous regressor and show results of a 2SLS, LIML and IV Probit models, respectively. Instrument validity
(overidentifying restrictions) is tested by Hansen J test in columns 3-4-6-7 and Amemiya-Lee-Newey minimum chi-sq
test in columns 5 and 8, respectively. Standard errors clustered at country level in are shown in parentheses in columns
1 and 2. Robust standard errors in parentheses in columns 3 to 8. *** p<0.01, ** p<0.05, * p<0.1
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Table 8. Financial Constraints, Tax Evasion and the Inefficiency of Legal Systems by Firm Size
(1) (2) (3) (4) (5) (6)
Small-sized Firms Medium-sized Firms Large-sized Firms
VARIABLES Probit IVProbit Probit IVProbit Probit IVProbit

TAXEV 0.143*** 1.228** 0.086** 1.599*** 0.044 1.065*

(0.041) (0.544) (0.037) (0.442) (0.065) (0.644)
JUDS 0.347*** -0.043 0.215*** 0.709** 0.150* -0.061
(0.071) (0.754) (0.054) (0.361) (0.082) (0.267)
TAXEV*JUDS -0.041** 0.023 -0.022 -0.254* -0.009 0.203
(0.019) (0.228) (0.015) (0.131) (0.025) (0.659)
CONFIDENCE 4.973*** 20.007* -4.409 -2.314 -0.976 -0.308

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(0.740) (11.191) (3.885) (4.066) (0.655) (1.066)
PASTINV 0.016 0.243 0.046 0.202 0.055 0.116
(0.077) (0.177) (0.068) (0.127) (0.112) (0.204)
AGE -0.009** -0.004 0.001 -0.004 -0.009** 0.000
(0.003) (0.008) (0.004) (0.006) (0.005) (0.009)

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AGE2 0.000 0.000 -0.000* -0.000 0.000** 0.000
(0.000) (0.000) (0.000) (0.000) (0.000) (0.000)
EXPORT 0.144 -0.058 -0.037 0.180 0.219* 0.406*

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(0.124) (0.210) (0.077) (0.147) (0.117) (0.211)
FDI -0.353*** 0.195 0.008 0.266 -0.210** -0.109
(0.123) (0.374) (0.089) (0.177) (0.104) (0.175)
PUBLIC_OWNED 0.188 0.472 0.070 0.443** 0.381** 0.392
(0.200) (0.537) (0.101) (0.204) (0.151) (0.259)

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LOG_GNP -1.829*** -10.833** 0.820 -2.204 -1.097* -2.174**
(0.265) (5.012) (1.366) (1.666) (0.631) (1.007)
EDU 1.231*** 6.890** -0.674 1.157 0.577* 0.962*
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(0.183) (3.204) (0.936) (1.099) (0.346) (0.531)
ETHNIC -6.374*** -29.816* 6.172 2.031 -0.204 4.437*
(1.092) (16.383) (5.703) (6.098) (1.206) (2.575)
CONSTANT -16.585*** -51.439 16.359 16.410 7.985 10.171
(2.453) (36.138) (13.007) (14.051) (5.110) (7.744)
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Country FE yes Yes yes yes yes Yes

Legal Origin FE yes Yes yes yes yes Yes
Firm Controls yes Yes yes yes yes Yes
Observations 1,525 1,463 1,919 1,835 841 816
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Instruments –first stage results

TAXEV
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G_CORR 0.238** 0.174* 0.259**

(0.110) (0.100) (0.166)
AV_LAW 0.061 0.087** 0.020
(0.038) (0.034) (0.052)
G_CORR*JUDS -0.044 0.014 -0.026
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(0.048) (0.115) (0.188)

TAXEV*JUDS
G_CORR -0.067 -0.390 0.052
(0.269) (0.253) (0.439)
AV_LAW 0.073 0.240** -0.076
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(0.093) (0.087) (0.139)

G_CORR*JUDS 0.215* 0.416*** 0.178
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(0.117) (0.100) (0.168)

Diagnostics
Overid Test (p-value) 0.87 0.89 0.82
Notes: The table presents multivariate analysis of Model (17), i.e. the impact of tax evasion (TAXEV), legal system
inefficiency (JUDS) and their interaction (TAXEV*JUDS) on firm financing constraints (CREDIT) by firm size. Column 1, 3
and 6 show results of a PROBIT model for small-, medium- and large-sized firms, respectively. Columns 2, 4 and 6 treat
TAXEV and TAXEV*JUDS as endogenous regressors and show results of IV Probit models for small-, medium- and large-
sized firms, respectively. Instrument validity (overidentifying restrictions) is tested by Amemiya-Lee-Newey minimum chi-
sq test. Standard errors clustered at country level in are shown in parentheses in columns 1, 3, 5. Robust standard errors in
parentheses in columns 2, 4, 6. *** p<0.01, ** p<0.05, * p<0.1

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Data Appendix
CREDIT Binary index that assumes value equal to 1 if the firm is financially constrained, and 0
otherwise. The original variable drawn from the Voices of the Firms 2000 dataset is
obtained by asking the managers to judge on a four-point scale, where “4” means a major
obstacle, “3” means a moderate obstacle, “2” means a minor obstacle and “1” means it is
no obstacle, how problematic the general constraint-financing is for the operation and
growth of your business. In this case we construct a dummy variable equal to 1 when the
original variable takes the values 3 or 4, and equal to 0 otherwise.
TAXEV Index of tax evasion measured as percentage of sales unreported to tax authorities. It has
been realized by asking the manager what percentage of total sales would he/she estimate
the typical firm in his/her area of activity keeps “off the books”. The variable ranges from

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1 to 7, being associated to the value 1 none evasion at all, to the value 2, 1-10% of total
sales unreported, to the value 3, 11-20%, to the value 4, 21-30%, to the value 5, 31-40%, to
the value 6, 41-50% and to the value 7, more than 50%.
JUDS Measure of the inefficiency of legal system which indicates the functioning of the judiciary

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as observed by firms. It is based on the following question asked to the company: please
judge on a four-point scale, where “4” means a major obstacle, “3” means a moderate
obstacle, “2” means a minor obstacle and “1” means it is no obstacle, how problematic the
general constraint-functioning of the judiciary is for the operation and growth of your

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business.
CONFIDENCE Country-varying measure of the efficiency of judicial system which reflects the average
level of firms’ confidence in the national legal system. In this case the questionnaire asks
the managers the degree to which they believe the system will uphold contracts and

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property rights in a business dispute. The scale ranges from 1 to 6, where a higher score
means a higher degree of confidence in the system.
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COURT Measure of the quality of the court system as perceived by firms. It has been realized by
asking the manager: “To what degree do you agree with the following statement: I am
confident that the legal system will uphold my contract and property rights in business
disputes”. The variable ranges from 1 to 6, where higher scores mean a lower degree of the
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quality of the court system.

PASTINV Variable that reflects the manager’s estimate of the growth of company’s investment over
the past three years.
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EXP_YN Dummy variable that takes the value 1 if the company exports outside its country and 0
otherwise.
FDI Dummy variable that takes the value 1 if the company operates in other countries and 0
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otherwise.
PUBLIC_OWNED Dummy variable equal to 1 if the firm is government-owned, equal to 0 otherwise.
AGE Number of years since the firm’s establishment.
SECTOR_M Dummy variable equal to 1 if the firm operates in the manufacturing sector, equal to 0
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otherwise.
SECTOR_S Dummy variable equal to 1 if the firm operates in the service sector, equal to 0 otherwise.
SECTOR_A Dummy variable equal to 1 if the firm operates in the agricultural sector, equal to 0
otherwise.
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SECTOR_C Dummy variable equal to 1 if the firm operates in the construction sector, equal to 0
otherwise.
SMALL Dummy variable equal to 1 if the firm is small-sized (number of employees 5-50), equal to
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0 otherwise.
MEDIUM Dummy variable equal to 1 if the firm is medium-sized (number of employees 51-500),
equal to 0 otherwise.
LARGE Dummy variable equal to 1 if the firm is large-sized (number of employees 500+), equal to
0 otherwise.
LOG_GNP Log of the GNP per capita in 1999. It is calculated according to the World Bank Atlas
method of converting data in national currency to US dollars.
LEGAL_ORIGIN Dummy variables for the origin of the legal system in a country, classifying a country’s
legal system as having its origins in French civil law (FR), German civil law (GE),
Scandinavian law (SC), Socialist law (SO), or Anglo-Saxon common law (UK). Source:
La Porta et al. (1999).
EDU Average years of schooling of population over 25 years of age in 1992.
ETHNIC Index of Ethnolinguistic fractionalization. It is computed as one minus the Herfindahl
index of group shares and reflects the probability that two randomly selected individuals
from a population belong to different groups. The variable takes values in the range

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between zero and one that are increasing in the degree of ethnic fractionalization. Source:
Alesina et al. (2003).
RULE OF LAW Index reflecting the quality of the legal system. It ranges between −2.5 and 2.5 with higher
values corresponding to better outcomes. The index includes perceptions of the
predictability and effectiveness of the judiciary, the incidence of crime and the
enforceability of contracts. Source: Kaufmann et al. (2005); data available at
www.worldbank.org.
AV_REG Index that captures how firms perceive that the information on the laws and regulations
affecting firm activity is easy to obtain. It ranges between 1 and 6; lower values are
associated to better outcomes.
TAX_REG Index that captures how firms perceive the tax administration regulatory area to be
problematic for the operation and growth of its business. It ranges between 1 and 4, where

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“4” means a major obstacle.
G_CORR Index of perceptions of corruption. It is based on the following question asked to the
company: please judge on a four-point scale, where “4” means a major obstacle, “3” means
a moderate obstacle, “2” means a minor obstacle and “1” means it is no obstacle, how

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problematic the corruption of bureaucracy is for the operation and growth of your business.

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Countries (observations)
Argentina (81), Bangladesh (21), Belize (26), Bolivia (82), Brazil (169), Bulgaria (86), Canada (79), Chile (90),
China (73), Colombia (88), Costa Rica (72), Croatia (100), Czech Republic (82), Dominican Republic (86),
Ecuador (77), El Salvador (84), Estonia (105), France (80), Germany (70), Guatemala (70), Honduras (42),

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Hungary (87), India (98), Indonesia (50), Italy (76), Kazakhstan (82), Lithuania (19), Malaysia (34), Mexico
(76), Pakistan (61), Panama (66), Perù (95), Philippines (89), Poland (183), Portugal (78), Romania (119),
Russia (411), Singapore (82), Slovenia (117), Spain (80), Sweden (76), Trinidad & Tobago (90), Turkey (116),
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UK (54), Ukraine (159), Uruguay (74), USA (80), Venezuela (78).
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Interaction Effect of Tax Evasion and Legal System Inefficiency on Firms’ Financial
Constraints

HIGHLIGHTS

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• We analyze the role of tax evasion and judicial efficiency on firm access to credit
• Our theory shows that each factor exerts ambiguous effects on credit rationing

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• Higher tax evasion and judicial inefficiencies increase firm financial constraints
• Tax evasion and legal system inefficiency mitigate each other’s negative effect
• The empirical results confirm the theoretical hypotheses

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