The Impact of Sectoral Development Aid on the Informal Economy

Both the informal economy and development aid are well-established fields of research. Yet only a very limited number of studies have directly examined the interaction between these two domains. Moreover, the existing literature largely overlooks the potential specific role of sectoral development assistance in building the institutional capacities of states, which can play a crucial role in domestic revenue mobilization in developing countries (Süttö, 2025). This thesis addresses this gap by posing two central research questions: Does development aid reduce the informal sector? And more importantly, is specific development aid, especially institutional aid, more effective, or is the impact of aid homogeneous? The hypotheses are formulated with reference to mechanisms that may shape how aid affects informality in practice. To test them, an unbalanced panel dataset covering 102 developing countries between 2003 and 2020 is employed, on which a gradual sequence of econometric techniques is applied: fixed-effects regressions, lagged independent variable models, and two-step system GMM estimators. The findings consistently show that higher aggregate aid inflows are associated with larger informal economies, while neither institutional nor other sector-targeted aid flows prove to be statistically...