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We wish to thank Emanuele Baldacci, Tito Cordella, Kevin Fletcher, Arye Hillman, Michael Keen, Timothy Lane, Eric Le Borgne, Ratna Sahay, and Juan Zalduendo for helpful comments on earlier versions of the paper.
Sanford (2002) reviews the main arguments and counterarguments on this issue. See also U.S. Treasury (2000). Bulow (2002) outlines the arguments in favor of converting loans to grants in the context of difficult debt negotiations.
Bräutigam (2000) also argues that aid creates enclaves in the economy when projects and consultants are exempted from import duties and other local taxes.
On the other hand, should donors condition their aid on good policies (e.g., as in proposed MCA), then aid-dependent countries could face increased pressure to maintain or improve the efficiency of their public institutions.
For example, Pack and Pack (1990) find foreign aid had a positive effect on domestic revenues in Indonesia, while Franco-Rodriguez and Morrissey (1998) find a negative relationship in Pakistan. McGillivray and Ahmed (1999) find that aid depressed tax revenues in the Philippines during the period of 1960–92. The results from the Cashel-Cordo and Craig (1990) study suggest that aid has had a positive impact on revenue mobilization among African countries and a negative impact on non-African countries. Heller (1975) finds a negative effect of aid on revenue for 11 African countries.
The assumption is that the aid comes in the form of budget support. If aid is tied to projects, it would require generation of counterpart funds for implementation of projects. In that case, ∂T/∂A > –1
Azam, Devarajan, and O’Connell (1999) find that when institutions are initially weak, foreign aid undermines institutional capacity building (i.e., revenue-raising capacity). As such, foreign aid eventually finances the whole public budget. There is some evidence that increased aid is associated with a higher level of rent-seeking activities (Knack, 2001, and Svensson, 2000), although Tavares (2003) presents evidence to the contrary.
The fungibility of aid refers to a situation where recipients reallocate resources that would have been spent for purposes now financed by foreign aid.
This is analogous to scenarios discussed by Feeny and McGillivray (forthcoming), using a similar analytical framework (equations (1) and (2)), where aid inflows lead to additional spending. In their framework, however, additional spending leads to increased (nonconcessional) borrowing rather than to increased tax effort. Catterson and Lindahl (1999) suggest that the mode of aid delivery, such as a “matching funds” system, can provide an incentive to boost domestic revenue generation. They find that in Tanzania, this system has created a “strong incentive for revenue collection.”
Both the Jarque-Bera and Shapiro-Wilk tests for nonnormal distributions are significant at the 1 percent level. The best equation fit was obtained using the semi-log specification. In addition, the log transformation of the dependent variable has the added benefit that predicted values, which are the exponential of the predicted log value, will always be positive.
Since most foreign assistance is routed through the central government budget, the nonavailability of data on revenue collected at the subnational level should not be a major handicap.
Data have been re-scaled such that higher values reflect weak institutions.
The Hausman test and the Breusch-Pagan specification test both indicate that the fixed effects model is preferable.
These estimates are drawn from the regression coefficients reported in column (4) and use the average values of revenues (about 21 percent of GDP) and of loans and grants (about 1.5 and 4 percent of GDP, respectively). The estimates are based on the sample underlying this regression. Given a semi-log regression of the form ln Y = β1 + β2*X + β3*(X2), the slope is equal to Y*(β2 + 2β3X), while the elasticity is equal to X*(β2 + 2β3X).
The other standard determinants of aid allocation are arms imports and total population.
To further assess whether endogeneity affects the results, we also estimated an instrumental variable regression of the baseline model, using initial income and initial population of recipient countries as instruments for aid, along with lagged values of aid. The results (not shown) are similar. In addition, we employed other estimation techniques (not shown) such as robust regression and maximum likelihood. We tested both the relationship between revenue and contemporaneous aid as well as revenue and lagged aid. The results are consistent with the baseline estimates in the magnitude, direction, and significance of the aid variables.
The use of the FGLS procedure in the estimation of time series cross-section models has been criticized for underestimating standard errors (see Beck and Katz, 1995). The PCSE procedure addresses this problem and assumes that disturbances are heteroskedastic and contemporaneously correlated across panels.