What Does Aid Do to Fiscal Policy? New Evidence
  • 1 0000000404811396https://isni.org/isni/0000000404811396International Monetary Fund
  • | 2 0000000404811396https://isni.org/isni/0000000404811396International Monetary Fund

Contributor Notes

Authors’, E-Mail Addresses: j-louis.combes@udamail.fr, stapsoba@imf.org.

Foreign aid is a sizable source of government financing for several developing countries and its allocation matters for the conduct of fiscal policy. This paper revisits fiscal effects of shifts in aid dependency in 59 developing countries from 1960 to 2010. It identifies structural shifts in aid dependency: upward shifts (structural increases in aid inflows) and downward shifts (structural decreases in aid inflows). These shifts are treated as shocks in aid dependency and treatment effect methods are used to assess the fiscal effects of aid. It finds that shifts in aid dependency are frequent and have significant fiscal effects. In addition to traditional evidence of tax displacement and “aid illusion,” we show that upward shifts and downward shifts in aid dependency have asymmetric effects on the fiscal accounts. Large aid inflows undermine tax capacity and public investment while large reductions in aid inflows tend to keep recipients’ tax and expenditure ratios unchanged. Moreover, the tax displacement effects tend to be temporary while the impact on expenditure items are persistent. Finally, we find that the undesirable fiscal effects of aid are more pronounced in countries with low governance scores and low absorptive capacity, as well as those with IMF-supported programs.

Abstract

Foreign aid is a sizable source of government financing for several developing countries and its allocation matters for the conduct of fiscal policy. This paper revisits fiscal effects of shifts in aid dependency in 59 developing countries from 1960 to 2010. It identifies structural shifts in aid dependency: upward shifts (structural increases in aid inflows) and downward shifts (structural decreases in aid inflows). These shifts are treated as shocks in aid dependency and treatment effect methods are used to assess the fiscal effects of aid. It finds that shifts in aid dependency are frequent and have significant fiscal effects. In addition to traditional evidence of tax displacement and “aid illusion,” we show that upward shifts and downward shifts in aid dependency have asymmetric effects on the fiscal accounts. Large aid inflows undermine tax capacity and public investment while large reductions in aid inflows tend to keep recipients’ tax and expenditure ratios unchanged. Moreover, the tax displacement effects tend to be temporary while the impact on expenditure items are persistent. Finally, we find that the undesirable fiscal effects of aid are more pronounced in countries with low governance scores and low absorptive capacity, as well as those with IMF-supported programs.

I. Introduction

Understanding the fiscal effects of aid has become an important issue for recipient countries. With most aid flows to developing countries channeled directly through government spending, it is crucial to assess the type of fiscal (dis)-incentives they produce, how these funds are allocated, and the overall impact they have on the fiscal stance. Investigating the fiscal consequences of aid is also timely given the current effort on domestic resources mobilization to fill financing gaps (see the third International Conference on Financing for Development in Addis Ababa in July 2015).

Studies in the literature have established different conclusions depending on the size of the sample, the timeframe, countries involved, and assumptions postulated. For instance, Moss, Pettersson and van de Walle (2008) and Benedek and others (2013) find that aid has a negative impact on tax collection. Other papers, however, find aid has a positive effect, including Clist and Morrissey (2011), Carter (2013) and Clist (2014). Ouattara (2006) even finds that the relationship is not significant. In addition, recipient countries can use aid for purposes not intended by the donor (Martins 2007, Acosta and de Renzio 2008, Morrissey 2015). In other words, aid intended to fund capital expenditure may be diverted to current expenditure.

Existing papers have focused on the average impacts of aid on fiscal variables. This approach may suffer from an identification problem and may mask the overall picture and some relevant policy messages. More conceptually, there is an agreement in the literature that the effect of aid on fiscal accounts is mostly non-linear. However, very few papers have explored non-linearities in the fiscal effects of changes in aid dependency. Existing studies have included either (or both) the aid variable and its squared term as covariates or the interaction between aid and macroeconomic variables (Clist and Morrissey 2011, Benedek and others 2013). Furthermore, the focus of the literature is often on the short-term, that is, the same-year effects of aid. However, aid may also have long-term effects on fiscal variables, given that aid is allocated usually for a multiyear period, and some projects supported by donors are often executed over several years. Thus, there are reasons to believe that structural increases or decreases in aid dependency may not have similar fiscal effects and may vary over time.

This paper focuses on the fiscal consequences of shifts in aid dependency. It provides a framework to examine the consequences of “almost-exogenous” aid events. Moreover, investigation of the shifts in aid dependency allows for an exploration of the static and dynamic impacts of the shifts by taking advantage of the heterogeneity around the shift points. In what follows, we propose an innovative approach by focusing on aid shifts and tests for the long-term effects. To this end, the paper applies the structural shift model of Bai and Perron (1998, 2003) to identify shift years in aid dependency. Thereafter, a probit model is used to explore the determinants of upward shifts (a shift to an increase) and downward shifts (a shift to a reduction) in aid dependency. To assess the fiscal effects of changes in aid dependency, we follow a treatment effect approach by adopting the propensity score matching (PSM) methodology. The PSM technique is a useful tool that accounts for potential selection bias when the treatment and the control groups have significant overlaps. The PSM has become a popular method of estimating causal treatment effects, but to the best of our knowledge, has not yet been applied in the aid literature. In addition, the PSM methodology offers a framework to assess the short-and long-term effects of the shifts in aid dependency on fiscal policy in developing countries.

Using a panel of 59 developing countries from 1960 to 2010, the paper finds that structural changes in aid dependency are frequent in developing countries. Significant increases in aid dependency (upward shifts) are less common as the economic development of recipient countries improves and natural resources rents increase. The likelihood of an upward shift in aid dependency increases with the acceptance of market-oriented policies or the presence of an IMF program. As for significant reductions in aid-to-GDP ratios (downward shifts), estimates indicate that significant reductions in aid dependency occur more often as recipient countries develop or have fewer diplomatic ties with the key players in international relations, i.e., the United States or Russia. In terms of the fiscal effects of these shifts in aid dependency, we first document the traditional effects argued in the literature. These are the tax and investment displacement effects (tax effort and public investment are undermined by aid inflows) and the “aid illusion” effect (aid inflows serve only to inflate current expenditure more proportionately). In addition, our approach allows us to explore the asymmetric effects of large and sustained aid inflows and the significant reduction in aid dependency, the persistency of the fiscal effects of aid, and non-linearities. Second, we find that upward and downward shifts in aid dependency have asymmetric effects on fiscal accounts. Large and sustained aid inflows undermine tax capacity and public investment while significant reductions in aid inflows tend to have no effect on fiscal ratios or the composition of revenues and spending. Only current expenditure is affected, by increasing with significant surges in aid inflows and significant decreasing with falls in aid inflows. Aid upward shifts induce a fall of about 2.3 percent in tax revenues as a share of GDP and 3.3 percent in capital expenditure in percent of GDP. Moreover, the tax displacement effect last only two years while the impacts on expenditure items tend to be longer, at least five years. Furthermore, the tax displacement effect, the “aid illusion” effect, and capital expenditure reduction after aid upward shifts are only present in countries with low governance scores and countries with low absorptive capacity. Finally, the tax displacement effect tends to be muted under IMF-supported programs. The results are robust to several alternative specifications.

The rest of the paper is organized as follows: Section II describes a brief review of literature and Section III specifies our econometric estimation strategy, while Section IV describes our data sources. Section V gives an overview of shifts in aid dependency. Section VI focuses on the main results and explores the role of the quality of governance and absorptive capacity and Section VII concludes.

II. Overview of the Literature

The impact of foreign aid flows on fiscal accounts has generated a prolific literature in the aid effectiveness debate. The literature can be categorized into two broad themes: (i) impact on tax effort and (ii) impact on expenditure.

Aid and tax effort. The relationship between aid and taxation cannot be determined a priori. Indeed, aid can be used in theory to improve tax collection but it can also have disincentive effects on tax effort. It is often argued that an increase in aid inflows will lower the government’s incentives to maintain or increase its tax effort, or even that tax effort can be undermined because of policy reforms linked to aid flows (McGillivray and Morrissey, 2001). In fact, foreign aid can a substitute for domestic tax revenue because it may influence tax effort in aid recipient countries by discouraging domestic tax effort (Teera and Hudson 2004, Chatterjee, Giuliano and Kaya 2012, Moss, Pettersson and van de Walle 2008, Carter 2013). Alternatively, other papers have argued that foreign aid may contribute to increase tax revenue through policy reforms bundled with conditional lending (see for instance Brun, Chambas and Guerineau 2008). The empirical literature has not reached a consensus on the impact of the effect of aid on tax efforts in recipient countries. Different studies have established different conclusions depending on the sample size, period, countries involved, and assumptions postulated. For instance, Moss, Pettersson and van de Walle (2008), Benedek and others (2013) find that aid has a negative impact on tax revenues. Other papers such as Clist and Morrissey (2011), Clist (2014) and Carter (2013) find a positive impact. Ouattara (2006) even find that the relationship to be not significant.

Aid and expenditure. It is well documented that aid is fungible. In simple terms, fungibility is a broad term that describes situations when recipients respond to aid by changing the way they use their own resources (see Morrissey 2015). Aid could be used to lower taxes, to fund projects in a different sector, or simply to line the pockets of corrupt officials. At the aggregate level, aid is fungible when one additional dollar of aid increases total government expenditure by less than one dollar (McGillivray and Morrissey 2004 and Morrissey 2015). It is fully fungible when government spending does not increase at all. Ouattara (2006), Lloyd and others (2009), and Martins (2007, 2010) have evidenced that aid is fungible. However, the aid fungibility debate considers only government expenditure such as current expenditure and capital development expenditure but does not deal with the broader fiscal impact of foreign aid over time. Our paper bridges this gap and studies the overall fiscal effects of foreign aid (expenditure and revenue sides).

III. Econometric Strategy

A. Shifts in Aid Dependency: A Structural Shift Approach

Given the fact that some shifts dates are difficult to detect by using a purely economic narrative, several authors use information criteria to estimate shift dates endogenously. As shown by Bai and Perron (1998, 2003), information benchmarks often used (e.g., Akaike, Bayesian, and Schwarz) can be biased when serial correlation is present.

We follow Bai and Perron in using test for multiple structural changes. Their methodology is sequential, starting by testing for a single structural shift. If the test rejects the null hypothesis that there is no structural shift, the sample is split in two and the test is reapplied to each subsample. This sequence continues until each subsample test fails to find evidence of a shift. The final number of shifts is equal to the number of rejections obtained with the parameter constancy tests.2 Specifically, for n shifts and (n+1) shifts, the basic data generating process considered is:

yt=μ1+δ1ϕt*+et*,1<t<[T/n]yt=μ2+δ2ϕt*+et*,[T/n]<t<[2T/n],,yt=μn+δnϕt*+et*,[(n1T/n)<t<T,(1)

yt is the dependent variable (total aid), ϕt* is the trend, T is the number of observations and et* is the disturbance term. The location of potential shifts is decided by minimizing the sum of squared residuals between the actual data and the average aid before and after the shift.3 We apply this methodology to the aid series. We first use total aid in real terms to determine shift date as described above. However, given the fact that the aid amount received by a country does not necessarily signal what its dependency is, we use both per capita aid and aid-to-GDP as further judgment criteria. Specifically, we calculate the average of the aid-to-GDP ratio before and after the shift date without overlapping shifts. We define “upward shift” when per capita aid and aid-to-GDP increase at the same time after a structural shift, and conversely “downward shift” when both decrease (Figure 1). In other words, an “upward shift” occurs when the averages of both the aid-to-GDP ratio and the aid per capita in a given level are higher than those observed in the previous years, and vice versa for “downward shift.” We also have few cases for which we cannot unequivocally conclude. These situations are treated as non-events.

Figure 1
Figure 1

Representation of Possible Shifts in Aid Dependency

Citation: IMF Working Papers 2016, 112; 10.5089/9781484382691.001.A001

Source: Authors.

In order to illustrate the relevance of our shift identification strategy we plot below the case of two selected country cases (Central African Republic and Nepal). Our identification method captures major shifts in aid dependency (Figure 2, left panel). The two countries have experienced both upward and downward shifts in aid dependency. The Central African Republic experienced its first upward shift in 1979, after the fall of Bokassa’s oppressive regime. From this year onward, the aid-to-GDP ratio significantly increased to 20 percent in 1984, followed by a relative fall in 1992. In 1997, the mutinies against President Patassé’s administration accelerated the decline in foreign assistance. A similar trend is also seen in Nepal (Figure 2, right panel) where an aid upward shift occurred in 1984, while aid downward shifts followed an economic crisis (1990) and a civil conflict (1997).

Figure 2
Figure 2

Shifts in Aid Dependency in Central African Republic and Nepal, Aid-to-GDP (percent), 1960-2010

Citation: IMF Working Papers 2016, 112; 10.5089/9781484382691.001.A001

Source: Authors. Vertical lines represent the identified years of shifts in aid dependency.

We turn now to the overall overview of shifts in aid dependency. Surprisingly, changes in aid dependency are frequent in developing countries. 93 cases of upward shifts and 48 cases of downward shifts were identified.4 This means that the unconditional probability of experiencing an aid upward shift in any year is 4 percent, and 2 percent for an aid downward shift. Being the main destination of foreign assistance, the likelihood of shifts in aid dependency is logically high in Africa (Figure 3, right panel). Africa has experienced 64 episodes of “upward shifts” and 34 cases of “downward shifts”. The majority of upward shifts occurred between 1970 and 1990. Downward shifts were common in the 1990s (Figure 3, left panel). The upward shifts that occurred in the late 1990s and early 2000s were correlated with the HIPC Initiative launched in 1996 by multilateral organizations including the IMF and the World Bank. The HIPC consisted of debt relief, which also included aid flows. Accordingly, the massive debt reduction is likely to translate into more upward shifts in aid dependency. The shifts are in magnitude large. On average, in aid dependency, the aid-to-GDP ratio increases by 5.9 percentage points during upward shifts and decreases by 7.1 percentage points during downward shifts.

Figure 3
Figure 3

Overview of Shifts in Aid Dependency, Numbers of Shifts, 1960-2010

Citation: IMF Working Papers 2016, 112; 10.5089/9781484382691.001.A001

Source: Authors.

B. Propensity Score Matching Approach

An important econometric issue in applying the propensity score matching (PSM) to assess the effects of shifts in aid dependency is the potential for non-random selection of observations. We use a variety of PSM techniques developed in the treatment effect literature to address the self-selection problem. Shifts (up or down) in aid dependency are taken as the treatment status. The propensity score is defined as the probability of a shift conditional on observable covariates. This likelihood is estimated from a regression model such as a logit or probit regression of the treatment variable conditional on covariates (see Heckman and others 1998, Dehejia and Wahba 2002). Put differently, the PSM involves a statistical comparison between the treated and the control group based on a two-pronged approach.

First, the probabilities of experiencing shifts in aid dependency for countries in a given year are estimated conditional on observable variables including economic conditions and country characteristics (selection model). Second, these probabilities (or propensity scores) are used to pair up country-years with aid shifts to those without aid shifts, and construct a “statistical” control group. This approach ensures the similarity of initial conditions in both the treated and the control groups. The control group provides in effect a proxy for the counterfactual, that is, for government accounts if an aid-experienced country had not experienced aid shifts. The impacts of aid shifts on fiscal variables are calculated as the mean differences in fiscal outcomes between the two groups.5 An important feature of the propensity score estimation is that the estimated propensity scores are determined independently from the outcome measure of interest. In this sense, this procedure allows us to remove systematic imbalances or differences between the treated and control cases prior to assessing any differences in any specific outcomes. Therefore, this method reduces the selection bias in aid allocation or in experiencing shifts in aid dependency.

Many matching methods have been proposed in the literature. In this paper, we focus on the four main ones: (i) nearest neighbor matching; (ii) radius matching; (iii) Kernel matching; and (iv) regression-adjusted local linear regression.

C. Selection Model: Estimating the Propensity Scores

We turn to the selection model. We follow the existing literature. The traditional explanatory variables of aid allocation are as follows: economic development and macroeconomic performance, alternative financial resources, exploitation of natural resources, quality of governance, exogenous shocks, and ideological considerations. In the following, we provide a literature summary motivating the choice of these factors.

Economic development and macroeconomic performance. First, aid allocation may be strongly linked to growth or macroeconomic performance in recipient countries. Such requirements aim to ensure that allocated aid is a source of development (Neumayer 2003b). Second, unsustainable public finances could justify a surge in foreign assistance. Indeed, difficulties in servicing public debt motivated the launch of the Heavily Indebted Poor Countries (HIPC) initiative in 1996 in order to help reduce debt ratios and provide policy space to qualified countries. On theoretical grounds, the relationship between aid and debt is mixed. Being a heavily indebted country is a negative fiscal signal of solvency, but at the same time, donors may help indebted countries in order to secure future partnerships. Third, IMF-supported programs could have important catalytic effects on the donor community: several donors rely on IMF involvement for budgetary support disbursements. Therefore, being or not under an IMF program may generate shifts in aid flows. Recently, Gündüz and Cristallin (2014) showed that countries following IMF-supported programs tend to receive more aid.

Alternative financial resources. International private financial flows may affect the allocation of aid. Indeed, private financing may reduce the need for aid. Private financing including FDI or remittances could act as a substitute for aid. For instance, Rajan and Subramanian (2008) and Fuchs, Dreher and Nunnenkamp (2014) observe that aid efforts weaken when other international financial flows increase. Harms and Lutz (2006) find that aid is negatively associated with foreign direct investment in countries with higher regulatory burdens. Some have argued that aid could be complementary to private financial flows. For instance, Bhavan, Xu and Zhong (2011) have found that foreign aid serve as complementary factor to foreign direct investment in South Asian economies. Furthermore, Donaubauer, Dierk Herzer, Peter Nunnenkamp (2014) have shown that aid for education is positively associated with foreign direct investment in Latin American countries.

Exploitation of natural resources. The exploitation of abundant natural resources may reduce the need for aid, and at the same time, donors may allocate aid to resource-rich countries based on political and economic interests. Dobronogov and Keutiben (2014) show that aid received by a number of resource-rich countries is on a par with their actual or potential revenues from natural resources.

Quality of governance. The impact of political and economic governance on the allocation of aid is ambiguous. Alesina and Weder (2002), Claessens, Cassimon and van Campenhout (2009) and Neumayer (2003a) document that countries with good governance tend to receive more aid, while Brautigam and Knack (2004), Dollar and Levin (2006) find that higher aid inflows are correlated with weak governance. We investigate whether “well-governed” countries are more likely to experience upward shifts or downward shifts in aid flows.6

Exogenous shocks. Shifts in aid dependency may be affected by exogenous shocks. We focus on natural disasters, conflict situations, and terms-of-trade fluctuations. Natural disasters, conflicts, or large terms-of-trade fluctuations may drive the likelihood of experiencing upward shifts or downward shifts in aid flows. For instance, Strömberg (2007) and Yang (2008) show that official aid increases significantly after disasters. It is also well documented that the majority of aid dependent countries are in conflict or in post-conflict (de Ree and Nillesen 2009). As for terms-of-trade shocks, Collier and Dehn (2001) find that aid works better in countries experiencing large fluctuations in the price of their commodity exports.

Ideological considerations. Foreign policy plays an essential role in international relations (Bailey, Strezhnev and Voeten 2013). Several studies have find that aid tends to be low when political ideology differs between the donor and the recipient (Alesina and Dollar 2000, Neumayer 2003a, Dreher, Schmaljohann and Nunnenkamp 2013). Others argue that the allocation of aid is dictated by political and strategic considerations, much more than by the economic needs and the policy performance of the recipients. Much aid is delivered on the condition that recipient countries implement market-oriented policies (Radelet 2006). Given the predominance of United States and Russia in international relations, we conjecture that developing countries diplomatically close to these countries are likely to receive more aid. At the national level, we check for the influence of nationalism, religion, and military in politics.

In order to investigate the drivers of upward shifts and downward shifts in aid dependency, we follow Hausmann, Pritchett and Rodrik (2005), hereafter HPR, by constructing an aid shift variable as a dummy taking the value 1 the year before, during, and after the shift identified by Bai and Perron’s (2003) methodology (and 0 otherwise). The 3-year window (as in HPR) is intended to capture uncertainty around the identification of the shift. We use a probit model with year dummies to control for unobservable covariant shocks. All other control variables are lagged by one year to mitigate the simultaneity problem.

IV. Dataset

We use a comprehensive dataset of 59 countries covering the period 1960-2010. It is noteworthy that only data availability and constraints related to Bai and Perron’s methodology restricted our sample.7 In addition, small countries with less than 1 million inhabitants were excluded from the sample. Data for aid are taken from the OECD’s QWIDS (Query Wizard for International Development Statistics) dataset, available online.8 We use aid data measured as a disbursement. Fiscal data including tax revenue, capital and current expenditures are compiled from various IMF datasets. All of these variables are expressed in percent of GDP. The data on GDP per capita, GDP growth, public debt over GDP, foreign direct investment, and remittances over GDP, trade openness defined as the sum of exports and imports over GDP, and natural resources rents over GDP are extracted from the World Bank’s 2014 World Development Indicators. The quality of governance is captured by the CPIA (Country Policy and Institutional Assessment) index which is a composite index representing the quality of policies and institutions. IMF programs, natural disaster and conflict variables are dummy variables from the IMF databanks, EM-DAT (CRED 2014) and Uppsala University’s Conflict Data Program (Jarstad, Nilsson and Sundberg 2012), respectively.

The terms of trade shocks series are constructed by using the Hodrick-Prescott (HP) filter to extract the cyclical component.9 The data on terms of trade are from CERDI’s database (CERDI 2014). The index of market-oriented policies and variables on the proximity with the United States and Russia are based on the UN votes data from Bailey, Strezhney and Voeten (2013). Data on the market orientation are estimated using a dynamic ordinal spatial model on votes made in the United Nations General Assembly and measure the degree of acceptability on votes related to market orientation policies. Proximity with the United States and Russia is defined as a similarity index, which is equal to the total of votes where both the recipient country and the United States or Russia agree over total of joint votes.

V. Results

A. Determinants of Aid Shifts

Table 1 reports probit estimates of the marginal effects for upward shifts and downward shifts in aid dependency.10 We only comment on significant results at the 5 and 1 percent levels. We find that upward shifts in aid dependency are less frequent as countries develop or natural resources rents increase. At the same time, they are positively correlated with the acceptance of market-oriented policies or the presence of an IMF program. Aid downward shifts are more likely when recipient countries develop or are less diplomatically close to the United States or Russia.

Table 1.

Determinants of Aid Shifts

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Note: Marginal effects and standard errors in parentheses. ***p<0.01, significant at 1%; **p<0.05, significant at 5%; *p<0.10, significant at 10%.

Upward shifts. The estimates are in line with expectations. The estimated marginal effect of GDP per capita is negative and statistically significant (see columns 1 and 3). An increase in per capita GDP by US$ 50 decreases the probability of an aid upward shift by 25 percent. In addition, natural resources rents are a significant factor in the structural changes in aid inflows. As expected, an increase in natural resources rents received reduces the need for aid. The marginal effect of natural rents is negative and robust on aid upward shifts (see columns 1 to 3). On average, an increase in natural rents by 1 percent of GDP decreases the probability of an aid upward shift by 14 percent. Conversely, as anticipated, IMF-supported programs are positively and significantly associated with a higher likelihood of upward shifts (see columns 1 to 3). This corroborates the argument that an IMF-supported program in developing countries plays a catalytic role in the donor community. Being under an IMF program increase the probability of experiencing a surge in aid inflows as percent of GDP by almost 37 to 42 percent. Regarding ideological considerations, Table 1 shows that the acceptance of market-oriented policies is associated with a higher probability of aid upward shifts. The related marginal effect is statistically positive and significant. More precisely, a one standard deviation increase in the score of the acceptance of market-oriented policies results in an increase of the probability of experiencing an aid upward shift of 21 percent. This finding is consistent with Radelet (2006) who stressed that market-oriented policies play a central role in aid allocation systems. Furthermore, countries with diplomatic proximity with the United States or Russia are more likely to experience an aid upward shift. The associated marginal effects are positive and statistically significant. More specifically, a one standard deviation increase in diplomatic proximity with the United States results in an increase of the probability of experiencing an aid upward shift of 40 percent, against 28 percent for political proximity with Russia. This finding is in line with the existing literature. For instance, Alesina and Dollar (2000) find that the destination of aid is dictated by political and strategic considerations. The remaining potential determinants are not statistically significant.

Downward shifts. As for aid downward shifts, we find that they are positively and robustly correlated with the level of development, and negatively with the proximity with the United States or Russia (see columns 1 to 3). The evolution of the development stage changes the probability of a reduction in aid. Aid inflows tend to decrease as countries become richer. An increase of per capita GDP of US$ 50 increases the probability of an aid downward shift by 50 percent. Diplomatic preferences also matter for structural changes in aid. A one standard deviation increase in political closeness with the United States induces a fall of 63 percent in the probability of experiencing an aid downward shift, compared with a fall of 57 percent for political proximity with Russia. Other potential factors are not statistically robust.

B. Effects of Aid Shifts

We use the PSM estimator to assess the effect of aid shifts (up and down) on fiscal accounts (tax revenue, capital and current expenditures).11 We compute bootstrapped standard errors based on 500 replications. The results are reported in Table 2. Overall, we find that with large and sustained aid inflows, fiscal authorities in these countries do not maintain (or increase) their tax effort, spend more on current expenditure at the expense of capital expenditure which is reduced as a share of GDP.

Table 2.

Effects of Aid Shift

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Note: Bootstrapped standard errors are reported in parentheses based on 500 replications. ***p<0.01, significant at 1%; **p<0.05, significant at 5%; *p<0.10, significant at 10%.

Upward shifts. As argued by several prior papers, we find evidence that aid upward shifts undermine tax collection efforts in recipient countries (columns 1-4). This tax displacement effect is strong and significant at the 1 percent level. Experiencing an aid upward shift leads to a loss of about 2.3 percent of tax-to-GDP. In other words, during aid upward shifts a one percentage increase in the aid-to-GDP ratio translates into a reduction in the tax-to-GDP ratio by about 0.4 percentage points.12 This finding is consistent with McGillivray and Morrissey (2001) and Benedek and others (2013) who argue that foreign aid creates disincentives for governments to maintain or step up domestic resource mobilization. On the expenditure side, there is evidence of competition effects of aid upward shifts. On the one hand, higher aid inflows tend to reduce public investment as a share of GDP. We find that aid upward shifts are robustly associated with a decrease in capital expenditure as a share of GDP. The effect is significant at the 1 percent significant level. Experiencing an aid upward shift yields to a decrease in capital expenditure by about 3.3 percentage points of GDP. This is equivalent to a decrease in capital expenditure by about 0.6 percentage points for a one percentage increase in the aid-to-GDP ratio during upward shift episodes. This is consistent with Franco-Rodriguez (2000). They find that aid reduces investment spending. On the other hand, aid upward shifts are associated with higher current expenditure, though significant at only the 10 percent level. After an aid upward shift, current expenditure tends to increase by 6.4 percent of GDP. Put differently, this corresponds to an increase of current expenditure by about 1.1 percentage points for a one percentage increase in the aid-to-GDP ratio. This last finding is consistent with consistent with the theory of “aid illusion” according to which aid can induce excess spending mostly on current expenditure items (McGillivray and Morrissey, 2000). We further estimate the effect of upward and downward shifts in aid dependency on each tax component: personal income tax, corporate income tax, value added tax (VAT), and trade tax. Results are reported in Table 3. Except for trade tax revenue, we find that upward shifts in aid dependency negatively affect all types of tax revenues. This effect is more pronounced for VAT revenue and less for corporate income tax revenue. Moreover, we find that the results for trade tax revenue are not significant.

Table 3.

Effects of Shifts in Aid Dependency on Revenue Items

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Note: Nearest-Neighbor matching estimator. Bootstrapped standard errors are reported in parentheses. They are based on 500 replications of the data. ***p<0.01, significant at 1 percent; **p<0.05, significant at 5 percent; *p<0.10, significant at 10 percent.

Downward shifts. For downward shifts, results are different (columns 5-8). Tax displacement is not observed. Capital expenditure remains unaffected. Only current expenditure is reduced after a large reduction in aid inflows. The effect is statistically robust at the 5 percent level. After an aid downward shift, current expenditure is reduced by about 2.8 percent. This is equivalent to a decrease in current expenditure by about 0.5 percentage points for every one percentage decrease in the aid-to-GDP during the downward shift episode. We also find that aid upward shifts and aid downward shifts have asymmetric effects of fiscal accounts in developing countries. Large and sustained aid inflows undermine tax capacity and public investment while large reductions in aid inflows tend to have no impact on tax and spending ratios. Only current expenditure is affected, by increasing with significant increases in aid inflows and decreasing with falls in aid inflows. Furthermore, we find that aid upward shifts in aid dependency create a crowding out effect on tax collection, whereas aid down-breaks do not affect tax-to-GDP ratio. However, given that total tax revenues s encompasses several components, the global effect may hide differences between different taxes. Estimates indicate that they have detrimental effects on corporate income tax and goods and services tax revenues. Downward shifts in aid dependency may lead to a decline in foreign help on capacity building in technical assistance, which in turn results in less means to collect taxes. On the contrary, we find that downward shifts in aid dependency have positive effects on trade tax revenues.

C. Non-linear Effects of Aid Shifts

In previous literature, the effect of foreign aid on government accounts has been addressed by using a linear framework. Few authors have tried to explore the non-linear effect of aid on fiscal policy. Existing studies have been run by including either both the aid variable and its squared term as explanatory variables or by interacting aid with other macroeconomic variables (see Benedek and others 2013, Gupta and others 2003, Morrissey, Islei and M’Amanja 2006, Brun, Chambas and Guerineau 2008, Clist and Morrissey 2011). Below, we explore the role of key non-linearities identified in the existing literature. We focus mostly on the presence of IMF-supported programs, the quality of governance, and the absorptive capacity.

IMF-supported programs and tax displacement

IMF program has an important role in revenue mobilization in developing countries. There is an increased reliance on revenue conditionality in IMF-supported programs through IMF’s technical assistance. However, evidence on the role of IMF-supported programs on revenue are limited and mixed. Bulir and Moon (2003) and Cho (2009) in 93 developing countries during 1951-2000 and found that IMF-supported programs had no effect on revenue collections. By contrast, Brun, Chambas and Laporte (2010) concluded that IMF-supported programs had a positive impact on total revenues in sub-Saharan Africa during 1984-2007. Recently, Crivelli and Gupta (2014) analyze the impact of revenue conditionality in IMF-supported programs on tax revenue collection in developing countries. They find that revenue conditionality embedded in IMF-supported programs has a positive impact on tax revenue. We further explore the role of IMF-supported in the fiscal effects of shifts in aid dependency in developing countries. To explore the role of IMF-supported programs, we follow split the sample into IMF and non-IMF program observations. The results are reported in Table 4. We find that the adverse effect on tax collection of upward shifts in aid dependency is muted under IMF programs. The tax displacement effect documented earlier is relatedly larger during upward shifts with no IMF-supported program. The estimated coefficient is significant and 3 times higher than the baseline estimates. In contrast, under IMF-supported program, the undesirable effect tends to be muted. This is in line with Brun, Chambas and Laporte (2010) and Crivelli and Gupta (2014). Conditionalities embedded in IMF-supported programs have a positive effect on revenue mobilization and help mute the tax displacement effect.

Table 4.

IMF-supported Programs and Tax Displacement

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Note: Nearest-Neighbor matching estimator. Bootstrapped standard errors are reported in parentheses. They are based on 500 replications of the data. ***p<0.01, significant at 1 percent; **p<0.05, significant at 5 percent; *p<0.10, significant at 10 percent.

Quality of governance and absorptive capacity and fiscal effects of aid

In this section, we assess the role of absorptive capacity constraints and the quality of governance. Previous literature has pointed out that developing countries can have difficulties in absorbing foreign aid (Guillaumont and Guillaumont Jeanneney 2006, Feeny and McGillivray 2011, Feeny and de Silva 2012). Absorptive capacity constraints limit the ability of recipient countries to manage aid productively. We follow Feeny and de Silva (2012) to construct an index of absorptive capacity. This index incorporates three major components: capacity constraints (including human capital and infrastructure constraints), governance constraints (including policy and institutional constraints), and donor practices.13 As for quality of governance, since the influential work of Burnside and Dollar (2000) who noted that aid is effective in a good policy environment, there has been an increasing attention on the role of the quality of governance on aid effectiveness (Alesina and Weder 2002, Neumayer 2003a). We therefore consider the Polity2 index of degree of democracy extracted from the Polity IV database (Marshall, Gurr and Jaggers 2012).

To assess the role of absorptive capacity constraints and the quality of governance, we divide our sample into two sub-samples determined by the median score.14 The results are reported in Table 5 for both the absorptive capacity and the quality of governance. It turns out that the tax displacement effect of aid, the “aid illusion” effect on current expenditure, and the decline in capital expenditure after aid upward shifts are only present in low absorptive capacity countries. When a country suffers from low absorptive capacity, aid undermines the recipient government’s incentive to invest in effective domestic tax collection, and diverts public investment into government consumption. When absorptive capacity constraints become more of a problem, unit costs for tax collection and investment rise and reduce recipient countries’ ability to mobilize tax revenue or invest in the economy. As for aid downward shifts, Table 5 shows that they are correlated with a decline in capital expenditure when the absorptive capacity is low.

Table 5.

Role of Quality of Governance and Absorptive Capacity and Fiscal Effects of Aid

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Note: Nearest-Neighbor matching estimator. Bootstrapped standard errors are reported in parentheses. They are based on 500 replications of the data. ***p<0.01, significant at 1 percent; **p<0.05, significant at 5 percent; *p<0.10, significant at 10 percent.

We now turn to the role of the quality of governance. The results are similar to those for absorptive capacity as regards aid upward shifts. Aid upward shifts lower tax collection by about 2.9 percent of GDP and capital expenditure when the recipient country has low governance score. As for aid downward shifts, they have fiscal effects only when the quality of governance is low. More specifically, aid downward shifts reduce government expenditure (total, current, and capital expenditure) and this crowding-out effect is related to the cuts in potential aid income.

In summary, we find that the tax displacement effect of aid, the “aid illusion” effect on current expenditure, and the decline in capital expenditure after aid upward shifts are only present in countries with low governance scores and low absorptive capacity countries.

D. Time-varying Effects of Aid Shifts

The focus of the literature is on the short-term effects of aid However, aid may also have long-term effects on fiscal variables given the fact that aid is usually allocated for a multi-annual period and some projects supported by donors are often executed in over several years. In this section, we investigate the dynamic effects of aid shifts on the fiscal accounts in recipient countries. From a policymaker viewpoint it is essential to assess whether the consequences identified above are permanent or short-lived. Indeed, over time, governments could implement necessary reforms and adapt to the fiscal consequences of aid upward shifts or downward shifts. On the contrary, governments may be unable to manage sustainably significant changes in aid dependency. To assess the potential dynamic effects of aid shifts on fiscal accounts, we follow Fang and Miller (2011) by using dynamic propensity score matching. This approach allows us to explore whether the fiscal effects of aid are lasting. We retain the 4-year window for the analysis. The results for both aid upward shifts and downward shifts are reported in Table 6.

Table 6.

Time-varying Effects of Aid Shifts

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Note: Nearest-Neighbor matching estimator. Bootstrapped standard errors are reported in parentheses. They are based on 500 replications of the data. ***p<0.01, significant at 1 percent; **p<0.05, significant at 5 percent; *p<0.10, significant at 10 percent.

Upward shifts. We find that the tax displacement effect lasts only two years. Indeed, the magnitude of the tax displacement effect of an aid upward shift decreases over time moving from 2.3 percent in T0 to 2.0 percent of GDP in T2. It also vanishes over two years, as the estimates for outer years are not statistically significant. Conversely, the effect of an aid upward shift on capital expenditure is permanent, lasting at least five years and even increasing over time. The negative effect of an aid upward shifts on capital expenditure increases over time until it reaches a crowding-out effect of about 4.0 percent of GDP at T4. In addition, the positive effect on current expenditure is permanent and around 6.5 percent of GDP (significant at only 10 percent) at least for four years.

Downward shifts. Table 6 shows the effects of aid downward shifts discussed above are persistent. Aid downward shifts do not affect tax collection over time. This finding is consistent with previous results, which showed that aid downward shifts are not correlated with tax revenue. However, the declines in current expenditure seem to be persistent over time until the year T4. However, this crowding-out effect is lower for current expenditure. Contrary to previous results, Table 6 shows that aid downward shifts negatively affect capital expenditure from the year T4.

VI. Robustness Checks

We check the robustness of our findings using several alternative specifications. We primarily focus on the use of larger trimming factor, the double robustness method suggested by Lunceford and Davidian (2004), and estimate multi-valued treatment effects. So far, we have used a trimming ε = 0.10, which represents a minimum number of 5 years between segments. Here, we test for ε = 0.15, corresponding to 8 years between segments. In other words, each aid dependency period must contain the minimum number of 8 years. The results are reported in Table 7 for the two first robustness exercises. Our previous findings are robust to these checks.

Table 7.

Robustness Checks: Fiscal Effects of Aid Shifts

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Note: Bootstrapped standard errors are reported in parentheses. They are based on 500 replications of the data. ***p<0.01, significant at 1%; **p<0.05, significant at 5%; *p<0.10, significant at 10%. We use the Nearest Neighbor Matching estimator.

VII. Conclusion

In this paper we take a closer look at the correlates and the fiscal effects of shifts in aid dependency. This study takes a different approach from the traditional aid allocation framework by looking directly at shifts in aid dependency the determinants of these shifts, and their effects on fiscal accounts. We adopted the structural shift model of Bai and Perron’s (1998, 2003) methodology to identify the shift points in aid for a sample of 59 developing countries over the period from 1960 to 2010.

We find that aid shifts are frequent in developing countries. Upward shifts tend to be correlated negatively with the economic development of recipient countries, the exploitation of natural resources, and positively correlated with the acceptance of market-oriented policies or the presence of an IMF program. In addition, countries with diplomatic proximity with the United States or Russia are more likely to experience an aid upward shift. As for aid downward shifts, we find that their likelihood is higher when recipient countries develop or do not have diplomatic proximity with the United States or Russia. We further assess the fiscal effects of these shifts in aid dependency using propensity score matching estimators which control for selection bias. Overall, we find that aid upward shifts and aid downward shifts have asymmetric effects on the fiscal accounts. We find that large aid inflows not only undermine governments’ tax efforts, but also create a crowding-out effect on capital expenditure. [Sustained external financing fuels current expenditure and creates the “aid illusion” effect. Aid downward shifts have negative effects on current expenditure. Aid spent on current expenditure items is just withdrawn when aid flows are reduced. These effects are more pronounced in countries with low governance scores, low absorptive capacity, and without an IMF-supported program. In addition, we find that the tax displacement effect last only two years while the impacts on expenditure items tend to last at least five years.

In summary, our investigation points that aid inflows should be managed with cautious especially to countries with low governance or absorptive capacity. Efforts and capacity building should focus on maintaining or even strengthening tax capacities or public investment implementation in recipient countries. Conversely, when countries graduate or are rationed from aid, efforts could focus on preserving current spending which is essential for inclusive growth, such as well targeted social programs.

Appendices

Appendix A1.

Distribution of Aid Shifts by Country

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Appendix A2.

Descriptive Statistics

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Appendix A3.

Components of the Index of Absorptive Capacity

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Source: Feeny and de Silva (2012)

Appendix A4. The Propensity Scores Matching (PSM) Method

As highlighted above, aid shift country-years are the treatment group whereas the remainder of the sample constitutes the control group. When estimating the effect of aid shifts on fiscal variables, the average treatment effect of aid shifts on the treated group (ATT) would be of interest and is given by:

ATT=E[ΔFVi1|ABi=1]EΔFVi0|ABi=1(A1)

With AB a dummy variable identifying countries experiencing aid shifts in any given year, ΔFVi0|ABi = 1 the change in fiscal variables that would have been observed if a country experiencing aid shift had not experienced such a shift, and ΔFVi1|ABi = 1 is the change in fiscal variable observed on the same country. However, given the fact that the initial macroeconomic conditions of countries experiencing aid shifts could be different from those of non-affected countries, it is not plausible to assume that fiscal variables would be the same in the absence of aid shifts. Therefore, a sizeable selection bias would be present. The propensity score matching method allows overcoming this problem of selection on observables problem. The key assumption to eliminate selection bias from equation (A1) through matching methods is conditional independence, which requires that conditional on some control variables X, the effect be independent of the aid shift dummy, i.e., EFVi0|ABi = 1, Xi] − EΔFVi0|ABi = 0, Xi would be zero. Under this assumption, equation (1) can be rewritten as:

ATT=E[ΔFVi1|ABi=1,Xi]EΔFVi0|ABi=0,Xi(A2)

Rosenbaum and Rubin (1983) propose that the treated units and control units can be matched on their propensity scores, which can be estimated by simple probit or logit models. A further assumption needed to apply PSM is the common support assumption ((p(Xi) < 1), which requires the existence of some comparable control units for each treated unit. When PSM is used, the ATT now can be estimated as:

ATT=E[ΔFVi1|ABi=1,p(Xi)]EΔFVi0|ABi=0,p(Xi)(A3)

The strategy consists of calculating the difference in the fiscal variable for observations with similar propensity scores (the probability of experiencing aid shift).

Appendix A5. Balance Tests

We examine whether the treatment model balanced the covariates by performing a statistical test. The Table below reports the probabilities of the over identification test for covariate balance. The null hypothesis is that the covariates are balanced. We cannot reject the null hypothesis that the covariates are balanced. We can trust the estimated treatment effect.

Appendix A5.

Components of the Index of Absorptive Capacity

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H0: Covariates are balanced. Table reports probabilities of Chi(2)

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