Report by Univ.-Prof. Jonas Bunte, Ph.D.

The shadow economy—economic activities that remain unregistered and outside official statistics—has long been a thorny issue for policymakers worldwide. While some workers find temporary refuge in informal jobs, the consequences of a large shadow economy are significant: distorted investment, inefficient resource use, lower wages, and higher income inequality. This raises an important question: Under what conditions do politicians actually act to reduce the shadow economy’s size?

In a recent article published in Economic Analysis and Policy, my co-author Les Stanaland and I examine how different types of foreign aid influence politicians’ willingness and ability to shrink the shadow economy. Our key insight is that not all aid is equal. We argue that bilateral loans, unlike grants, give office-motivated politicians both the means and the incentive to increase formal public employment. Loans arrive in predictable tranches and require repayment, prompting politicians to invest in projects—such as infrastructure—that create stable, formal jobs. Grants, by contrast, are more unpredictable and need not be repaid, often making them less effective tools for systematically expanding formal employment.

To test our argument, we conducted a comprehensive empirical analysis across 75 developing countries between 2000 and 2015. We used the Currency Demand Approach to estimate the size of the shadow economy and combined this with data on bilateral loans and grants. Our findings reveal a clear pattern: when countries receive loans, the shadow economy tends to contract significantly, while grants show no such effect. Moreover, mediation analysis confirms that loans reduce the shadow economy primarily by expanding formal public employment, not merely by raising tax revenues. These results hold even after accounting for selection bias and potential endogeneity through advanced statistical techniques, including instrumental variables.

These insights carry important policy implications. While foreign aid is often criticized for enabling corruption or fostering dependency, our study shows that certain types of aid—specifically loans—can encourage politicians to invest in formal job creation, thereby reducing the size of the shadow economy. For policymakers and development practitioners, this suggests that designing aid programs with predictable funding structures and built-in incentives for productive investments can have broader benefits for economic stability and social welfare. In short, how aid is structured may determine whether it fuels hidden economies or helps bring economic activity into the light.

Access the paper here: The shadow economy and foreign monetary transfers - ScienceDirect

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