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Public Debt, Sovereign Default Risk and Shadow Economy

  • Ceyhun Elgin
  • Burak R. Uras

This paper analyzes the interactions between government's indebtedness, sovereign default risk and the size of the informal sector. We test an underlying theory that suggests that in societies with limited tax enforcement, the presence of informality constrains the set of pledgeable fiscal policy alternatives, increases public debt and the implied probability of sovereign debt restructuring. The hypotheses that we test in our empirical analysis are: a larger size of the informal sector is associated with (1) higher public indebtedness, (2) higher interest rates paid on sovereign debt, (3) a higher level of financial instability and (4) a higher probability of sovereign default. The empirical results from cross-country panel regressions show that after controlling for previously highlighted variables in the literature that could explain the variation in financial instability, sovereign default risk and public indebtedness, the size of informality remains as a significant determinant of these variables.

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Paper provided by Bogazici University, Department of Economics in its series Working Papers with number 2012/10.

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Date of creation: Oct 2012
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Handle: RePEc:bou:wpaper:2012/10
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