Fiscal austerity and informality: Twin deficits as a cushion in Latin American countries

• The effectiveness of fiscal austerity is notably influenced by the size of the shadow economy. • In economies with high informality, the twin deficits phenomenon buffers the adverse impacts of austerity by facilitating exchange rate depreciation and current account adjustments. • Tax-based fiscal consolidations prove more effective for enhancing the current account balance and mitigating external vulnerabilities. This paper uncovers a new transmission channel that explains the muted effects of fiscal policy in economies with high levels of informality. Using a novel dataset on fiscal consolidations in 14 Latin American and Caribbean countries (1989–2016), I provide evidence supporting the twin deficits hypothesis in highly informal economies. Real exchange rate depreciation and improvements in the current account balance help cushion the negative impacts of fiscal consolidation. In contrast, in economies with smaller informal sectors, this mitigating effect is absent, leading to significant output contractions as a result of austerity. These findings shed new light on how informality shapes the macroeconomic consequences of fiscal policy, offering valuable insights for policymakers in emerging and developing countries.