The Fiscal Effects of Aid in Developing Countries: A Comparative Dynamic Analysis

Since the late 1990s there has been considerable growth in research on aid effectiveness, and a shift in the policy stance towards increasing aid. Whereas the World Bank (1998) was rather sceptical regarding aid effectiveness, the Commission for Africa (2005) proposes doubling aid to Africa, arguing that aid is effective and can be made even more so. One of the reservations expressed in World Bank (1998) was fungibility — aid intended for investment (that promotes growth) may be ‘redirected’ to consumption spending (which does not promote growth), and this undermines aid’s effectiveness. This masks the possibility that consumption spending may have beneficial effects. For example, there is evidence that aid increases spending on social sectors (health, education and sanitation) and that aid itself contributes to improving aggregate welfare (Gomanee et al., 2005). This is reflected in the argument that aid should be used for ‘boosting public expenditure — on vital areas such as education, health and infrastructure’ (Commission for Africa, 2005: 293). The fundamental issue here is the impact of aid on the level and allocation of public spending (a related issue is the effectiveness of such spending). Identifying the fiscal effects of aid is a prerequisite to understanding the macroeconomic effectiveness of aid (McGillivray and Morrissey, 2000). This chapter is a contribution, providing empirical estimates of the fiscal impact of aid for a sample of nineteen developing countries (fourteen middle-income and five low-income).1