Literature Review

Foreign aid is one of the major sources of external finance in many developing countries and an important component of public sector budget. Net Official Development Assistance (ODA) to all developing countries receiving DAC ODA has averaged between 7.8 and 14.3 percent of their GNI, amounting to around 18– 45 percent of average central government expenditure during 1990-2011.

The relatively high share of foreign aid in government budgets in some countries have raised concerns about aid dependency of recipient countries and related fiscal management issues. Generally, foreign aid is allocated to or passes through aid recipient governments and finances public goods or services. Therefore, foreign aid affects the size or composition of government expenditure particularly in the low-income countries, which are relatively more dependent on foreign aid (Remmer [2004]).

At the same time, foreign aid may also have impact on tax revenue and borrowing. In fact, it has been suggested that foreign aid can substitute for domestic tax revenue since it may influence tax effort in aid recipient countries by discouraging incentives to mobilize tax revenue domestically (Chatterjee et al.

[2007]; Moss et al. [2008]). On the contrary, foreign aid may also contribute to increased tax revenue due to policy reforms that follow conditional lending and such increased tax revenue may contribute to reducing the level of borrowing of aid recipient countries (Morrissey [2012]).

The fiscal response studies model the interactions among major fiscal variables including public expenditures (investment and consumption), government revenue and domestic borrowing in one research framework in order to analyze the effects of foreign aid on them. However, the empirical results are mixed.

Heller (1975) first pioneered a fiscal response model of public sector in aid recipient countries by developing a cross-section time-series econometric model of the public sector of eleven African countries, focusing on the interactions among several categories of public expenditure and of domestic and foreign revenues. He further distinguishes the impacts between alternative types of aid (grants and loans) and colonial legacy on budgetary structures (Anglophone and Francophone countries).

In his study, Heller finds that foreign aid generally increases investment and reduces the level of both domestic taxes and borrowing at the same time. The magnitude of these effects and the precise response of public consumption vary depending on the type of aid, with grants having stronger pro-consumption bias and loans being more pro-investment. In terms of colonial legacy, grants tend to increase consumption than investment in Anglophone countries but induce more investment in Francophone countries.

It is no surprise that the impact of grants and loans differ. While grants have a more stimulative impact on public consumption and a weaker impact on investment, loans tend to increase investment than consumption. In addition, an inflow of grants tends to induce tax reductions whereas a loan inflow is more likely to induce reductions in borrowing. Such results may reflect the fact that African countries are unwilling to expand public spending through a sharp increase in their debt obligations.

Since Heller, due to limited availability of consolidated data for a large sample of aid recipient countries over a reasonable period of time, many of those previous fiscal response studies have focused on country-specific studies using time-series data (Gang and Khan [1991]; Otim [1996]; Rubino [1997]; Iqbal [1997];

Franco-Rodriguez et al. [1998]; McGillivray and Ahmed [1999]; Franco-Rodriguez [2000]). They have tested varying impacts of the types and sources of foreign aid on recipients’ fiscal behavior and have come up with mixed results.

For example, Gang and Khan (1990) test the aid-public investment hypothesis using time-series data for India. The results of this study confirm Heller’s findings in general. Contrary to the previous works, foreign aid is generally used for development purposes as intended by donors with no significant leakage into consumption purposes. They also find that, in India, bilateral aid pulls resources out of consumption and puts them into development projects. Gang and Khan (1999) confirms again that the chances for success are greater for development strategies involving both growth and distribution if more bilateral aid as opposed to multilateral aid is provided to India although the impact further depends on how policy-makers allocate the aid funds.

Otim (1996) also analyzes the impact of foreign aid on government fiscal behavior, using a pooled sample of three low-income South Asian countries:

Pakistan, India and Sri Lanka. He finds that grants leak into consumption more than loans and leads to the conclusion that if the purpose of aid is to generate investment, it is more helpful if donors extend loans to developing countries than by giving grants. However, his results suggest that both grants and loans increase the taxation effort.

Similar results are found by Franco-Rodriguez et al. (1998), who studied the fiscal impacts in Pakistan from 1956 to 1995. Their study finds that aid induces a slight overall increase in investment, but a significant decrease in tax revenues that is more than offset by reduced consumption expenditures. Increased borrowing is needed to compensate for the loss of tax revenue.

Other earlier fiscal response studies also show mixed results across countries.

For instance, foreign aid has significantly negative impact on total spending and tax revenue in Indonesia (Rubino [1997]), but positive impact in the Philippines (McGillivray and Ahmed [1999]). Foreign aid has also varying effects on borrowing, as it shows positive association in Pakistan, but significantly negative

one in the Philippines. In addition, the effects of different types of foreign aid on fiscal variables seem to matter, as shown in Otim (1996) and Feeny and McGillivray (2010), but the effects again vary by country. In overall, it is hard to generalize the empirical results especially from such a small number of country-specific studies. Therefore, there is a strong need to expand the scope of countries and the period of time covered when conducting panel-data-based studies.

This paper tries to meet the need.

<Table 1> A Summary of Fiscal Response Studies

Incremental Impact of Fiscal Response Studies

Study Sample Tax Revenue Public

Investment

Rubino (1997) Indonesia -1.4 -0.8 -0.7

Iqbal (1997) Pakistan 1.6

Franco-Rodriguez

et al (1998) Pakistan -3.6 0.1 -2.4 0.9

McGrillivray and

Ahmed (1999) The Philippines -0.1 -0.02 0.02 -1.81

Franco-Rodriguez

(2000) Costa Rica 0.05 -0.02 0.07 -0.08

Feeny and

Dollar (2000) 40 countries 0.53649 (grants)⁵⁾

Ouattara (2006) 68 countries 0.077 0.004 -0.134

Benedek et al

(2012) 118 countries -0.0055 (grants) 0.0001 (loans)

Source: McGillivray and Morrissey (2001), Burnside and Dollar (2000), Ouattara (2006), Feeny and McGillivray (2010), Benedek et al. (2012).

1) Human capital related expenditures, consisting of expenditures in the health and education departments.

2) All other recurrent expenditures, defined as expenditures of all other departments and on special appropriations such as the retirement of debt.

3) Human capital related expenditures, consisting of expenditures in the health and education departments.

4) All other recurrent expenditures, defined as expenditures of all other departments and on special appropriations such as the retirement of debt.

5) Log transformed to be compared with Benedek et al. [2012] and the current study.

Since the 2000s, economists including McGillivray and Ouattara (2006) have departed from previous fiscal response literature by using panel data techniques and a relatively large sample of aid recipient countries. In terms of methodology, previous studies generally used estimation techniques such as Three-Stage Least Square (3SLS) or the Nonlinear Three-Stage Least Square (N3SLS) methods due to the possibility of endogenous nature of foreign aid and recipients’ fiscal decisions.

These techniques were reviewed by McGillivray and Morrissey (2004) and noted to be highly difficult to estimate and sensitive to data, often resulting in inconsistent estimates of core parameters. Ouattara (2006) also points out that despite the presence of such limitations in methodology, little effort has been made since the initial fiscal response study of Heller (1975).

In an attempt to overcome such limitations, Ouattara (2006) uses a relatively sophisticated technique known as the system GMM estimator to dynamic panel⁶⁾, for a group of developing countries over the period of 1980-2000.⁷⁾ In this paper, he finds that aid flows are not used to increase government consumption, but tend to induce increases in development expenditures such as education and health. The impact of aid on government revenue collection is positive but statistically insignificant, implying that aid has only a weak relationship with revenue effort. In terms of borrowing, the results suggest that recipient governments tend to substitute borrowing for aid, almost, on a one-to-one basis. Similar findings are also reported in his study (Ouattara [2006]), which uses fixed and random effect estimators.

In sum, it is hard to generalize the empirical results from previous fiscal response studies, as the results show complex and varying effects by country. This is partly due to the fact that results are highly sensitive to sample, model specification, and the use of different econometric techniques, implying that results and policy implications can be susceptible to the estimation methods used in the analysis (Morrissey [2012]).

In this context, this paper attempts to analyze the effectiveness of foreign aid in terms of its impact on fiscal behavior of aid recipient countries by using the extensive panel data, i.e., the most recent and extended time period of the Millennium Era (1990 to 2011) and comprehensive data sets of 40 developing countries.⁸⁾ The fiscal response to aid in this period will be compared with that of the earlier periods, as demonstrated in earlier panel-data studies. In addition, in order to run additional robustness check, this study runs the same model with two different periods of the Millennium Era, based on the Millennium Declaration in the

6) Outtara uses system-GMM estimator rather than standard GMM estimator, which has been extensively used in applied economics in recent years, as Windmeijer (2005) documents that in the presence of weak instruments the standard GMM has large biases and low asymptotic precisions.

7) Samples are not specified in the Ouattara’s 2006 paper.

8) Countries with less than observations in the dependent variables and the major independent variable, grants and loans, have been dropped for robustness of the results (5 missing values allowed).

year 2000: the first half of the Millennium Era, 1990-1999 and the second half 2000-2011. This comparison may also give additional information on the fiscal response seven during the Millennium Era.

In terms of methodology, this study takes the fixed and random effect estimation approach rather than 3SLS or system-GMM, which has been used in the previous papers, because the potential endogeneity of the major independent variable, i.e., foreign aid (grants and loans), has shown to be non-existent in the model through the Durbin-Wu-Hausman (DWH) test.