Searching in the Shadows: The Impact of Economic Sanctions on Informal Economies

Abstract

To date, most research on the consequences of sanctions has explored how foreign economic pressure influences the formal sector of targeted economies. This study instead focuses on explaining the ways in which economic sanctions might affect the size and growth of informal economies. We assert that the sanctions-induced economic disruptions and hardships in target economies distort the normal incentive structure that affected firms and individuals have for doing business in the formal economy, leading them to increase their participation in the shadow sector. To assess our theory, we conduct a global quantitative analysis of sanctions’ effects on size and growth of their targets’ informal economies from 1971 to 2005. Employing a wide variety of estimators and robustness checks to evaluate the direction of causality, we find strong evidence that economic sanctions increase their targets’ informal economies. This suggests that economic sanctions do not just harm their targets’ economies; they actually alter how their constituents participate in them. This has significant implications for efforts to understand the broader economic consequences of sanctions.