Fiscal Adjustments and the Shadow Economy in an Emerging Market

Abstract

We build an open-economy dynamic stochastic general equilibrium (DSGE) model that allows us to: (i) derive a time series for labor informality in Brazil spanning the period 2004–2018, whose evolution is consistent with the behavior of the main series provided by Pesquisa Nacional por Amostra de Domicílios (PNAD); (ii) run dynamic simulations showing that, in the presence of a large informal labor market (around 50% of the total labor force), expenditure-cutting measures lead, at worst, to mild short-run recessions in the formal sector and are likely to foster public debt sustainability. Likewise, adjustments through some kinds of distortionary taxation, mainly the corporate tax, and to a lesser extent, the consumption tax, also seem to improve both public debt dynamics and fiscal collection without a significant cost in terms of output. Thus, in countries with large informal economies experiencing fiscal woes, expenditure-based consolidations, as well as some sorts of tax-based adjustments, should be relied upon.