The economic development of some countries is greatly hampered by international credit constraints and by fractious domestic politics. Lack of access to international capital causes under-provision of productive public investments in health, education, and infrastructure even in countries with perfect political systems. Flawed political institutions compound the problem. When central governments are weak and public spending decisions reflect the political influence of organized constituencies rather than the general public’s interests, patterns of government spending are distorted and economic performance suffers. If excessive appetite for rents dominates public spending decisions, government resources are diverted from productive activity toward rent-seeking. In such circumstances, foreign transfers and other potentially favorable developments may actually cause recipient countries to be worse off—a phenomenon Tornell and Lane (1999) termed “the voracity effect.”
In this paper, we examine the economic effects of international assistance (loans and grants) to a credit-constrained country in which interest groups compete for government transfers as in Tornell and Lane.1 We find that loans conditioned on public investment alone—that is, loans directed exclusively at investment—will not necessarily increase growth or welfare in the recipient country, even when conditions can be perfectly enforced. Thus project conditionality may fail to produce the desired results in countries ravaged by voracious politics. However, extending conditionality to take into account the underlying drivers of a country’s fiscal policy can help reduce distortions in the composition of government spending and increase growth and welfare. This prediction is roughly consistent with the aid patterns historically. Broadly, speaking, international development loans were initially conditioned on the implementation of individual projects. Over time, as the limits of project conditionality became apparent, multilateral and bilateral donors expanded the scope of their conditions. The budget support loans used by donors focus on reforms in the recipients’ domestic fiscal policies, including of the level and composition of spending, public expenditure management systems, and reform of tax policies and administration.
In our application of Tornell and Lane’s idea, organized interest groups devote time to “producing” transfers from a central government. These groups allocate their resources (time, effort, and money) to what Bhagwati (1980, 1982) and Bhagwati and Srinivasan (1982) have dubbed directly unproductive activities: protests, strikes and lobbying aimed at changing laws and regulations, generating unproductive government employment, and obtaining national funds for unproductive local projects.2 These unproductive activities lower current output and the future returns of public investments. We consider a country that is poor for these reasons and, additionally, because it is confronted with international borrowing constraints.
The presence of directly unproductive activities complicates the ability of international assistance to mitigate the effects of borrowing constraints. We show that development loans that firmly condition, dollar-for-dollar, on productive public spending on investment can fail to increase growth and welfare. A transfer paradox of sorts emerges: the weak central government faces pressure to maintain transfers to interest groups and to repay loans by raising future tax rates. In political equilibrium, interest groups have incentives to further divert time away from productive activity and toward the “production” of government transfers. The result is lower overall welfare in the economy, because the return on investment is lowered and may not even exceed loan repayment. A favorable exogenous policy shock, loans from international donors, results in lower welfare and growth!
One way to prevent the voracity effect is to extend the conditions of international loans to tackle the underlying distortions in the country’s public expenditure policies. The guiding principle is that the repayment of debt should not favor rent-seeking over productive activity. Toward this end, loan conditions should be extended to require that (1) future tax rates be maintained and (2) loan repayments be financed by cuts in those government spending categories that are particularly susceptible to corruption and rent-seeking. Reducing the incentive to seek rents will increase productive activity and guarantee that improvements in growth and welfare materialize. While this principle is clear in theory, identifying the appropriate cuts in government spending may not be obvious to the donors in reality. For example, corrupt public “investment” projects can be used as a vehicle for making transfers to favored groups (Keefer and Knack, 2007). Knowing which spending to cut requires detailed knowledge of the country’s politics. For this reason, we stress that the cooperation of the recipient country’s finance minister, backed by sound technical, cost-benefit analysis of projects, and with input from other stakeholders, is crucial in establishing the appropriate fiscal conditions.
In practice, detailed fiscal conditions of the sort advocated here have long formed an important part of the conditionality featured in programs of adjustment and reform supported by the International Monetary Fund (IMF) and the World Bank. Initially, the conditions imposed by the international financial institutions (IFIs) focused on broad macroeconomic, price and trade-related reforms, such as ceilings on the rate of expansion of domestic credit and the budget deficit, and liberalization of prices and trade. Detailed fiscal conditions reflect the reality that in many low-income countries, the composition of government spending is distorted, reflecting the political influence of powerful interest groups. In the absence of detailed fiscal conditionality, the composition of government spending in many low-income countries would be distorted away from productive spending, including much-needed investments in human and physical capital. A cap on the overall budget deficit that did not take aim at the bias in favor of unproductive spending and transfers to politically connected interest groups might succeed in meeting short-run stabilization objectives but would fail to raise growth in the recipient. Empirical work finds that fiscal adjustments that require changes in the composition of spending in low income countries, toward investment and away from consumption, are important for growth (Baldacci, Clements, and Gupta, 2003, survey research on this topic).
In response to lackluster growth in some countries receiving IFI assistance, the focus of conditionality gradually shifted away from short-term macro-economic, trade and price adjustment, to encompass more complex structural fiscal, financial, and corporate sector issues. In particular, starting in the mid-1980s, IFIs began to routinely sponsor comprehensive public expenditure reviews (PERs) that scrutinized the efficiency of various components of public spending against the marginal cost of raising funds, including through borrowing. These PERs typically advocate reallocation of spending away from categories favoring powerful interest groups and toward deserving but under-represented constituencies. The most important recommendations of these reviews eventually become conditions of IFI loans.3 In recent years, governments and the international community have redoubled their efforts to improve the mix of public spending in order to meet the United Nations Millennium Development Goals (MDGs) by 2015. With aid flows projected to increase markedly, and with many aid recipients still falling short of achieving several of the MDGs, there has been increased analytical scrutiny of the level and efficiency of different categories of public spending. At issue is the appropriate level, composition, and phasing of aid-financed spending between investment in basic infrastructure (such as roads, energy, and irrigation) and spending on social sectors. Quantitative models, such as the World Bank’s Maquette for MDG Simulations (MAMS) focus on this distinction, as do econometric examinations of the impact of different types of aid.4
Our paper formalizes the mechanism through which public spending gets distorted and provides a welfare justification of the need for detailed fiscal conditions. In our model, as well as in practice, detailed conditions aim at improving the composition of government spending and reducing the resources devoted to directly unproductive activities. Such detailed conditions may have a powerful effect on policies so long as the domestic political economy is not too adverse. In some situations, however, the domestic political system is so configured that external carrots and sticks cannot have decisive impact. In such environments, lending and aid selectivity is the appropriate response of altruistic donors.
Amador, M., 2008, Sovereign Debt and the Tragedy of the Commons, (unpublished; Department of Economics, Stanford University). Available via the Internet at www.stanford.com/~amador/tragedy.pdf.
Baldacci, E., B. Clements, and S. Gupta, 2003, “Using Fiscal Policy to Spur Growth,” Finance and Development, Vol. 40, No. 4, pp. 28–33.
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Bhagwati, J.N., and T.N. Srinivasan, 1982, “The Welfare Consequences of Directly-Unproductive Profit-Seeking (DUP) Lobbying Activities: Price Versus Quantity Distortions,” Journal of International Economics, Vol. 13 (August), pp. 33–44.
Clements, B., S. Gupta, A. Pivovarsky, and E. Tiongson, 2004, “Foreign Aid: Grants versus Loans,” Finance and Development, Vol. 41, No. 3, pp. 46–9.
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)| false Kaufman, D., M. Mastruzzi, and D. Zaralita, 2003, “ Sustained Macroeconomic Reforms, Tepid Growth: A Governance Problem in Bolivia?” in In Search of Prosperity: Analytic Narratives in Economic Growth, ed. by ( D. Rodrick Princeton, New Jersey, Princeton University Press).
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)| false Sundberg, M., and H. Lofgren, 2006, “ Absorptive Capacity and Achieving the MDGs: The Case of Ethiopia,” in The Macroeconomic Management of Foreign Aid: Opportunities and Pitfalls, ed. by ( P. Isard, L. Lipschitz, A. Mourmouras, and B. Yontcheva Washington, International Monetary Fund).
Tornell, A., P.R. Lane, and A. Velasco, 1992, “The Tragedy of the Commons and Economic Growth: Why Does Capital Flow from Poor to Rich Countries?” Journal of Political Economy, Vol. 100, No. 6, pp. 1208–18.
World Bank, 2006, Turkey Public Expenditure Review, World Bank Report No. 36764-TR, Europe and Central Asia Region (December 18). Available via the Internet: //siteresources.worldbank.org/INTTURKEY/Resources/361616-1173282369589/tr_per_cr.pdf.
Alex Mourmouras is chief of the European Division at the IMF Institute. Peter Rangazas is professor of economics at Indiana University-Purdue University in Indianapolis. The authors thank an anonymous referee and the editor, Robert Flood, for useful comments and suggestions on an earlier draft.
Tornell and Velasco (1992) and Amador (2008) also set up economic environments in which domestic interest groups demand too much spending from the government because the costs of spending are spread over the entire economy. Interestingly, Amador shows that it is in the interest of an “over-spending” country to repay its foreign debt. In our paper, we simply assume that foreign debts are repaid. We then examine the consequences for debt repayment on rent-seeking and the productivity of investment project funded by the loans.
In their analysis of how governance problems reduce economic growth, Kaufman, Mastruzzi, and Zaralita (2003) discuss the key sources of patronage politics, several of which relate to fractious political environments. In such environments, politicians face heightened incentives to maintain and expand support from opposing groups through offers of public jobs and other perks. Often coalition governments are formed based on explicit agreements for sharing state patronage. Patronage politics motivates the need for tax and expenditure and civil service reforms in many developing countries. See Agénor (2004, pp. 592–94).
Examples are the public sector reform loans of the World Bank and the loans granted under the IMF’s Poverty Reduction and Growth Facility. See, for example, World Bank (2006).
On the evolving focus of World Bank conditions, see Koeberle and Malesa (2005, p. 52). On the trends in structural conditionality in IMF-supported programs, see IMF (2001, pp. 8–13) On the appropriate level and mix of different types of aid-financed spending to meet the MDGs, see Sundberg and Lofgren (2006, pp. 147–50). See also Clemens, Radelet, and Bhavnani (2004). Again, the sensible strategy of encouraging public infrastructure investment is subject to the proviso that corrupt “investment” projects can also be the sources of pure transfers to interest groups and of unproductive government consumption.
Our setup is similar to Tornell and Lane (1999) in that there are m different interest groups that compete in a Nash game for public funds. Beyond this basic assumption the details of the two approaches are different. Tornell and Lane focus on taxing physical capital to finance transfers. Agents have the option to avoid the tax by investing in less productive, but untaxed, nonmarket firms. In equilibrium the net-of-tax return to market and nonmarket investments must be equated. The voracity effect results because any increase in the productivity of market investments must be met by a perfectly offsetting rise in taxes and government transfers, so as to maintain equality in rates of return across market and nonmarket sectors.
One could generate similar results with a model of labor-leisure choice, rather than focusing on the choice between productive work and rent-seeking. However, rent-seeking activity seems to be a more important source of poverty in low-income countries, where output per worker is very low, than is leisure demand. For a given level of recorded employment, the greater the fraction of the employment that is allocated to unproductive activities, the lower would be average worker productivity. The rent-seeking model also produces sharper predictions because it is a pure time allocation model (between two income generating activities) and therefore includes no wealth effects that make predictions about the labor-leisure choice theoretically ambiguous.
Many poor countries have difficulty collecting taxes on wages and instead rely on taxing physical capital. However, introducing capital would not add any new insights to the analysis. In a small open economy, all capital taxes are passed on to labor in the form of a lower pre-tax wage rate. For our purposes, this is equivalent to taxing wages directly.
A more general specification would allow rent-seeking to be a function of the size of the government’s budget. Here we focus on the case where international assistance is allocated, dollar for dollar, to raise public investment, which implies that the discretionary budget is unaffected by outside loans. We show that even in this idealized setting, development loans may fail to improve welfare.
Easterly (2001, p. 82) argues that increased education will not lead to increased production when the incentives are not right. “One clue as to why education is worth little more than hula hoops to a society that wants to grow comes from what educated people are doing with their skills. In an economy with extensive government intervention, the activity with the highest returns to skills might be lobbying the government for favors. In an economy with many government interventions, skilled people opt for activities that redistribute income rather than activities that create growth.”
Higher taxes would also hit the wages paid to those in unproductive government employment. However, interest groups would work to protect their after-tax wages by lobbying for higher before-tax wages, so that their net transfer from the government remains the same. Thus, taxes will primarily lower the reward to productive work.
In stressing the importance of cutting government consumption to repay loans, we do not deny that in many developing countries productive public officials are paid too little, and unproductive ones are paid too much. Although difficult to implement, the best policy would be to cut government consumption overall and reallocate spending to productive government employees.
Note that central government taxes would not change under the loans to subnational governments. There is not even an indirect effect on tax rates from the increased human capital in the second period because higher human capital would increase the tax base and the transfer expenditures proportionally.
Such a policy has the potential to strengthen the hand of weak central governments in their attempt to resist spending initiatives by local governments. For example, in Argentina the initiative for public spending comes from the provinces, while responsibility for raising revenue is often passed off to the central government (Mussa, 2002, p. 14). A decentralized fiscal policy with soft subnational budget constraints is considered to be a general problem in Latin America (Stein, 1999).
We say potentially, because we are assuming that grants are used exclusively to finance public investments, as are loans, and the other features of public expenditures and taxes remain fixed. However, in practice, grants have been associated with a decline in tax revenue collection (Clements and others, 2004). Thus, at least some of the grants are used to lower taxes. Because grants are not permanent sources of revenue, it is unlikely that taxes are lowered by a legislated cut in tax rates, which would reduce rent-seeking in favor of productive spending. Instead, the loss in tax revenue may be due to special tax exemptions or lack of tax enforcement that favors particular interest groups and which are transfers that reward rent-seeking. These considerations caused Clements and others to recommend that broad conditions be placed on grants to prevent losses of tax revenues. This is equivalent to requiring that grants funds be used dollar-for-dollar to increase investment (as we have assumed here).
Our numerical analysis only produced outcomes where the optimal loan was at least as large as the first-best loan.