Are fiscal rules efficient on public debt restraint in the presence of shadow economy?

• The spread of the shadow economy hinders the effectiveness of fiscal rules in reducing public debt. • A powerful impact of the shadow economy on public debt was proved in low-income countries. • To increase the efficiency of fiscal rules, governments should work towards reducing the shadow economy and corruption. This paper provides an analysis of the role played by fiscal rules and the shadow economy in the evolution of public debt. Thus, we investigate the effectiveness of fiscal rules in limiting the level of indebtedness in the presence of a shadow economy (SE) in 194 advanced, emerging, and developing countries over the period 1995–2021. The SE harms public revenue collection and leads to an increase in the budget deficit. Better management of public finances is difficult to achieve in the presence of a SE. We find that governments should try to limit the spread of SE to achieve sustainable public finance and maintain public indebtedness within reasonable limits. The results from the cointegration technique suggest that in the long run, the efficiency of fiscal rules is conditioned by the decrease of the SE, and only after this prerequisite is attained can a favorable evolution of public debt be expected. The empirical findings confirm the significant contribution of the SE to the public debt increase and the ineffectiveness of the fiscal rules applied. [ABSTRACT FROM AUTHOR]