Informality and Fiscal Adjustment under Stress: Ev-idence from Developing Economies

José Alves and Alexandre Ernesto da Costa António

No 2026/0426, Working Papers REM from ISEG - Lisbon School of Economics and Management, REM, Universidade de Lisboa

Abstract: How does informality shape fiscal adjustment when governments face debt stress? We study 122 non-advanced economies from 1990 to 2020 by embedding shadow-economy exposure in fiscal reaction functions, debt-dynamics decompositions, and state-dependent impulse responses. The central design uses predetermined pre-2008 informality and the common timing of the Global Financial Crisis. Countries with higher pre-crisis informal-ity run a larger post-2008 primary balance, a differential of roughly 0.6 to 1.5 percentage points of GDP, against a sample-mean deficit near 0.8 percent after absorbing country effects, common shocks, and region-year shocks; event-study estimates cannot reject parallel pre-trends before the shock (a test with limited power), and the post-2008 break survives netting out a linear pre-trend. The result survives country trends, outcome win-sonorization, alternative event windows, country-level randomization inference, and full leave-one-country-out diagnostics. Mechanism tests show that the primary balance is the main adjustment margin, with weaker evidence of revenue effort and little support for a clean expenditure, growth, snowball, or debt-stock channel. A fiscal-rule adoption event study provides a non-GFC scope check: pre-trends are clean, but the informality differ-ential is short-lived rather than persistent. We do not find a stable universal pooled inter-action coefficient; fixed-effects, IV, and GMM estimates of the average debt-response gradient are often imprecise. The evidence supports a narrower claim: informality be-comes fiscally consequential when stress tightens governments’ room for manoeuvre, forcing sharper primary-balance adjustment rather than indicating stronger underlying fiscal capacity.

Keywords: Shadow economy; fiscal sustainability; fiscal reaction function; time-varying parameters; debt dynamics; fiscal space; developing countries. (search for similar items in EconPapers)
JEL-codes: C23 E26 E62 H63 O17 (search for similar items in EconPapers)
Date: 2026-08
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