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

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.