Paper short abstract:

We empirically analyze how Official Development Assistance and Illicit Financial Flows jointly affect the income distribution and inequality in Low- and Middle-Income-Countries and investigate the main moderating factors.

Paper long abstract:

Illicit money involves transnational transactions involving hidden flows, such as phantom investment, that deprive developing countries of domestic resources for development, but also pose a continuing challenge for sustained growth, governance, and effective social justice. This negative influence of illicit money contrasts with the role of foreign aid, which is seen as beneficial to countries in the Global South. However, it is still unclear empirically to what extent the interplay between aid and phantom investment influences income inequality. Moreover, it is yet to be understood how these two financial flows interact with the institutional setting to affect balanced development and inequalities. This is of particular importance, as inequality is strongly related to elite capture, creating a vicious circle of increasing inequalities with rising incomes for a small elite that manages to reap the benefits from illicit money and foreign aid, whereas the rest of the population is left behind or even made worse off. This paper assesses the effects of phantom investment and foreign aid on inequality in the Global South, with a focus on their interaction using a standard two-way fixed-effects model and the System-Generalized Methods of Moments. The results show that phantom investment tend to worsen inequality, especially in countries that depend heavily on foreign aid.