The shadow economy and foreign monetary transfers

Abstract

Office-motivated politicians have incentives to reduce the size of the shadow economy. Public employment is one of the most effective and credible means to increase formal employment. In this article, we examine how the availability of foreign aid enables politicians to reduce the shadow economy by funding public employment. We argue that bilateral loans and bilateral grants differ significantly in this regard. Bilateral loans provide politicians with both the resources and incentives to expand public employment, whereas bilateral grants do not. Our findings indicate that the shadow economy contracts when governments receive loans, while no such effect is observed when they receive grants. Furthermore, we confirm that loans reduce the shadow economy through an increase in formal public employment. Our empirical analysis addresses potential endogeneity and selection bias. Additionally, we test the proposed mechanism using mediation analysis. Our findings offer policymakers valuable insights into how the financial conditions of foreign aid can influence the economic conditions of vulnerable populations.