We provide a theoretical and empirical study of the relation between financial development and the size of
the underground economy. In our theoretical framework agents allocate investment between a low-return
technology which can be operated with internal funds, and a high-return technology which requires external
finance. Firms can reduce the cost of funding by disclosing part or all of their assets and pledging them as collateral.
The disclosure decision, however, also involves higher tax payments and reduces tax evasion. We
show that financial development (a reduction in the cost of external finance) can reduce tax evasion and
the size of the underground economy. We test the main implications of the model using Italian microeconomic
data that allow us to construct a micro-based index of the underground economy. In line with the
model's predictions, we find that local financial development is associated with a smaller size of the underground
economy, controlling for the potential endogeneity of financial development and other determinants
of the underground economy.