An Examination of the Empirical Literature of Aid Effectiveness and Government Fiscal Behavior

Scientific Essay, 2010

18 Pages


An Examination of the Empirical Literature of Aid Effectiveness and Government Fiscal Behavior

Ehizuelen Michael Mitchell Omoruyi


The issue behind the effectiveness of external finance has been studied from diverse perspectives. The question of whether external finance assists poor nations to develop in a sustained manner is still mired in controversy. Development assistance may be given to governments; but the effectiveness will crucially rely on their fiscal response. The relationship between the fiscal activities of the government and foreign aid is however, not straight forward, for the reason that some part of the development assistance is fungible. The preponderance proof from empirical literature on the effectiveness of aid proposes that external finance has not had a noteworthy influence on growth in most receiving nations. However, there are some proofs that external finance has had some significant impacts on development in most conducive policy climates. Most of the evidence concerning the correlation between aid and the key channels via which its influence on growth could flow on domestic saving and investment is mixed. This is because some indication shows that aid has had significant influence on investment and domestic saving in nations where adjustment efforts have been sustained.

Keywords: Aid effectiveness, Fiscal response, Government expenditure, Growth, Saving, Investment

1.0 Introduction

The outpouring of foreign aid for over four decades by the early champions has been judged by its purposes, and not by its outcome. External assistance programs have been perpetuated and expanded not for the reason that they have produced significant success, but for the reason that giving external finance still appears like a good idea. Nevertheless development assistance has rarely accomplished anything that nations could not have been able to accomplish themselves. In addition, foreign aid has often encouraged the receiving governments’ worst tendencies—assisting to underwrite policies and program that have starved millions of individuals and derailed struggling economies. So, with the “make-or-break” situation surrounding aid effectiveness, some analysts conclude that, most developing countries that have received hundreds of billions of dollars of foreign aid since the creation of post-war financial system at Bretton Woods are still struggling to build their economies irrespective of the massive outpouring of aid (Moyo and Ferguson, 2010). So the question of whether development assistance helps poor nations to develop in a sustained manner is still mired in controversy. Notwithstanding the large amounts of Official development assistance (ODA) that numerous low income nations have received for decades, it seems that the anticipations of the early champions of development assistance was for aid to boost investment and growth in low-income nations by supplementing domestic savings or reducing foreign exchange constraints, but the fact is that their expectations have not been met.

There have been a lot of debates around the academic community that, apart from taking advantage of development assistance to achieve high and sustained growth, thereby reducing the need for additional aid; there should also be a policy change that will allow these receiving nations to be creative in generating domestic funds for expenditures and less dependent on aid. Some analysts have even put forward that aid flows have allowed government to postpone reform.[1] Somewhat on account of tighter aid budgets in donor nations, and also because of concerns that numerous development assistance beneficiaries seem to be stuck in poverty, various donors have been looking for means to make aid more effective.[2] Most development assistances are not effective in numerous countries because most recipient governments implement “pocket policy”¾ a policy that is design to benefit those in power and not the general public. Aid has to be allocated to those countries pursuing good policies and not those countries pursuing “pocket policies”, to a larger extent; it is argued, than is already the case. If aid is allocated to those countries pursuing good polices, then aid effectiveness and aid selectivity issues will be solved simultaneously. Every donor wants their aid to ‘build capacity’ whether in form of known-how, physical assets or human capacity which is directly or indirectly productive of better incomes.

Most of their capacity-building impact comes via government action, because the greater part of aid is channeled through governments. Every donor is concerned if, through ‘fungibility’, their aid finances expenditures are unrelated to longer-term growth and poverty reduction. This paper examines the key findings of empirical literature over the past two decades, concerning the influence of development assistance on poverty alleviation and economic growth. External finance comes in several forms, which can be categorized into two broad classifications: development aid which comprises of technical assistance, program aid, project aid and emergency assistance. The next form is the emergency assistance which is envisioned to provide temporary relief from the effects of natural disasters and other destructive events like war, rather than to stimulate development and growth. Most debates on the influence of aid on growth are mostly related with the extent to which external finances upsurges investment in human and physical capital in various receiving nations.[3] Previous empirical analysis on macroeconomic influence of foreign aid concentrated on the relationship among aid, domestic savings and growth; by employing the Harrod- Domar kind of models (e.g., the two-gap model) which was used as the theoretical foundation for regressions.

For some years now, aid effectiveness literature has drawn on a successful empirical growth literature to use more sophisticated models, as well as addressing some of the econometric weakness of previous studies. Furthermore, the studies have also given more careful consideration to incentives in the donor-recipient association and how these might encourage beneficiary governments to pursue policies that perpetuate aid reliance and undermine growth.[4] Far from the studies that are based on growth theory, there are aspects in the aid effectiveness literature that center more closely on particular channels via which the influence of aid on growth might flow. There are two specific aspects of interest to IMF operations; they are the influence of aid on the real exchange rate (that is to say, aid as a source of “Dutch disease”) and the influence of aid on government budgets (that is, the “fiscal response” to aid). Most issues in the fiscal response literature consist of the fungibility of aid resources, and the influence on the private sector of aid-funded government expenditure (that is, the crowding in vs crowding out). The question most experts are asking with regard to the “Dutch disease” effects of aid is how can government policy help to mitigate the erosion in export competitiveness?

The organization of this paper follows this order: The first section deals with the introduction of the paper. The second section looks at the literature review and practices of aid effectiveness and their fiscal responses. The third section will provide some of the range of findings in the literature as regard to the influence of aid on growth. The fourth section will be concentrating on the influence of aid on domestic savings and investment. It will also look at the interactions between government budget and aid. The fifth section will highlight how the incentives in the donor-recipient association, and the nature of political regime in recipient nations, might influence the effectiveness of aid. The sixth section will cover the possible “Dutch disease” effect of aid. The seventh section will conclude the paper.

2.0 Literature Review of Aid Effectiveness and their Fiscal Responses

The past three decades have witnessed enormous outpouring of surveys on the effectiveness of aid and their fiscal response. The subject has been a central and recurring topic with which numerous economists, subscribing to the diverse paradigms of development thinking, have grappled. Questions like whether aid works or not has been approached from diverse ideological and methodological perspectives. For example, according to the approach that follows the model developed by McGuire (1978) and is concerned with the question of aid fungibility. External finance is said to be fungible if the receiving country employs it for the intended purposes other than those intended by the givers. The author assumption is that the aim of given official development assistance (ODA) is to fund particular activities; the question is whether the flow is diverted to other aims. Based on the author assumption, if the official development assistance (ODA) intended for investment is really diverted to government consumption expenditure, then the potential growth influence of aid may possibly decrease.[5] In general, government investment expenditure is considered to make more contribution to growth than government consumption expenditure. So, external finance should not be channeled to government consumption expenditure, but rather diverted to government investment spending because of its significant contribution to development. Most of the surveys from the following authors Swaroop et al. (2000), Khilji and Zampelli (1991), Feyzioglu et al. (1998), and Pack and Pack (1990, 1993) followed this approach.

Another model was developed by Heller (1975), where he was able to assume the Utility-maximizing behavior for the government. The author examines the pattern of diverse components of government spending when encountered with a budget constraint which is defined by aid, borrowing and revenue.[6] As a result of this, the governments are met to set numerous targets for expenditures as well as setting revenue targets for borrowing and tax. The government later tries to maximize their aim, either in form of social welfare or economic growth. Heller (1975) emphasizes that by employing these techniques will help the government to achieve their set targets for expenditure and revenue. The author believes that the realization of spending and revenue targets maximizes the set objectives. External finance can either adjust the government revenue, borrowing targets or spending targets. The government can as well change its both revenue, borrowing and spending targets in response to external finance. Most of the fiscal response literature states that the significance of recipient government behavior for the effectiveness of aid is implicit. Specifically, most authors from other perspectives attempt to investigate the receiving government’s response to external finance flows, based on the decisions between numerous sources of revenue such as the domestic borrowing and taxation as well as some parts of spending such as the recurrent government expenditure and public investment (Otim, 1996). Numerous governments are viewed in the fiscal response model as organisms that try to optimize the value of some ultimate target like the rate of economic growth. In actual fact, governments engage in this act by steering certain intermediate policy variables to their desired levels.

Most of these policy variables are dissimilar from one study to the other, subject to the interest of the investigator, but usually consist of variables such as aid, public borrowing from domestic sources, tax revenue, government recurrent expenditure and public investment expenditure (these variables can sometimes be disaggregated subject to the interest of the examination). The study specified government utility functions as a quadratic loss function; at the point where the government reaches maximum utility, and if the targets for the decision variables are met. Based on this fact, the utility function is then optimized subject to the budget constraint that spending cannot surpass revenues. On this ground, a system of structural equations is derived, and the parameters of this system are usually estimated by employing a non-linear three stage least squares (NL3SLS). Just for the fact that these models deals with the behavior of different regimes, the application of empirical techniques are mostly employed. Additionally, it depends on the purpose of the survey, because most of the models are often modified in diverse ways that it creates complications when comparing them. Let's say the development assistance can be disaggregated into diverse sources, such as private, multilateral and bilateral; it can also be categorized by type, (loans, grants etc.). According to Heller (1975), he proposes that official grants have higher probability of leakage into government consumption, whereas loans tend to fund public investment. Other studies were conducted by Cashel-Corodo and Craig (1990), in their survey, they tried to differentiate between bilateral and multilateral aid. The authors found out that multilateral aid seems to be more preferable to bilateral aid among recipient countries. Other stylized fact is based on the survey of Morrissey et al. (2002), were they reported that external finance often decreases domestic borrowing.


[1] For instance, in a current proposal to the U.S. government on “a new partnership for growth in Africa” (HIID, 1997), the authors assert that by being open-ended, foreign aid has failed to put pressure on governments to make the policy choices needed to mobilize domestic resources for development.

[2] For summary of current trends in donor aid policies see chapter IV in IMF (1995). The annual reports of the Development Assistance Committee (DAC) of the OECD are an excellent source for information on donor policies.

[3] For highly indebted countries, program aid may possibly take the form of debt relief to reduce a debt “overhang” and contribute towards creating a qualitatively different environment in which a virtuous cycle of capital inflows and growth has a chance of getting started.

[4] White (1992a) and White and Luttik (1994) contain comprehensive surveys of the aid effectiveness literature through the early 1990s. For a less detailed treatment but which still covers the key issues, see White (1992b). Influential papers in the early literature involve Griffin (1970), Papanek (1972 and 1973) and Weisskoff (1972).

[5] Even if aid is employed in the intended manner, it permits the government to raise its consumption expenditure or finance other projects, which may not be so productive. In that case, too, aid effectiveness will be low.

[6] In a further studies Gang and Khan (1991) and Khan and Hoshino (1992) extended the approach.

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An Examination of the Empirical Literature of Aid Effectiveness and Government Fiscal Behavior
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Michael Mitchell Omoruyi Ehizuelen (Author), 2010, An Examination of the Empirical Literature of Aid Effectiveness and Government Fiscal Behavior, Munich, GRIN Verlag,


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