Austerity reexamined: Uncovering the role of the shadow economy

Abstract

This paper challenges the conventional belief that austerity measures inherently trigger economic contraction. Leveraging a novel narrative dataset of fiscal consolidations across 14 Latin American and Caribbean countries (1989–2016), constructed by Carrière-Swallow, David, and Leigh (2021), I uncover that the impact of fiscal policy hinges significantly on the shadow economy's magnitude. Specifically, the output downturn post-fiscal consolidation is notable only in low-informality settings, with real GDP declining at impact by 1.12 % following tax hikes and 2.77 % in response to spending cuts. This effect is accompanied by crowding-out of domestic demand and higher unemployment. Intriguingly, economies with high informality levels exhibit resilience against austerity induced recession. This result holds regardless of the level of economic development, institutional quality, trade and financial openness, and the debt-to-GDP ratio.