## _wp16112

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---

### Methodology and data
- Study period: panel of 59 developing countries from 1960 to 2010.
- Identification strategy:
  - Structural shift model of Bai and Perron (1998, 2003) to identify shift years in aid dependency.
  - Probit model to explore determinants of upward and downward shifts in aid dependency.
  - Propensity score matching (PSM) methodology to assess fiscal effects of changes in aid dependency and to account for potential selection bias.
- Focus: static and dynamic impacts of shifts in aid dependency, including short- and long-term effects and exploration of non-linearities.
- Dataset specifics:
  - Panel of 59 countries covering 1960-2010; small countries with less than 1 million inhabitants excluded.
  - Aid from OECD QWIDS measured as disbursements.
  - Fiscal variables (tax revenue, capital and current expenditures) from IMF datasets; all expressed in percent of GDP.
  - Controls from World Bank 2014 WDI: GDP per capita, GDP growth, public debt/GDP, FDI/GDP, remittances/GDP, trade openness, natural resource rents/GDP.
  - Governance: CPIA index; Polity2 used later for democracy measure.
  - IMF program, natural disaster, conflict dummies from IMF databanks, EM-DAT (CRED 2014), and Uppsala Conflict Data Program.
  - Terms-of-trade shocks constructed via HP filter (smoothing parameter 6.25 for annual data).
  - Market-orientation and diplomatic proximity indices from UN voting-based measures.

### Identification of aid shifts and matching strategy
- Structural-shift approach:
  - Uses Bai and Perron multiple structural change tests (sequential testing for shifts).
  - Primary series: total aid in real terms; further judgment criteria: aid per capita and aid-to-GDP.
  - Definition of shifts:
    - “Upward shift” when both per capita aid and aid-to-GDP increase after a structural shift.
    - “Downward shift” when both per capita aid and aid-to-GDP decrease after a structural shift.
    - Ambiguous cases treated as non-events.
  - Trimming parameter ߝ =0.10 used; with sample period 1960-2010 each segment must contain minimum number of 5 years.
  - Sequential testing uses 0.10 significance level.
- Propensity Score Matching (PSM):
  - Shifts treated as treatment status; propensity score estimated via logit/probit.
  - Matching methods: nearest neighbor matching; radius matching; Kernel matching; regression-adjusted local linear regression.
  - Aid-shift dummy constructed as 1 the year before, during, and after the Bai-Perron identified shift (3-year window); probit with year dummies used for estimation.
  - Selection model covariates include: GDP per capita, IMF-supported program indicator, FDI, remittances, natural resource rents, CPIA/Polity2, natural disasters, conflict, market-orientation index, diplomatic proximity to United States and Russia.

### Overview of shifts in aid dependency
- Identified shifts (1960-2010):
  - 93 cases of upward shifts.
  - 48 cases of downward shifts.
  - 28 indeterminacies in which per capita aid increases but aid-to-GDP decreases.
- Unconditional annual probabilities:
  - Aid upward shift: 4 percent.
  - Aid downward shift: 2 percent.
- Regional and temporal patterns:
  - Africa: 64 upward-shift episodes and 34 downward-shift episodes.
  - Majority of upward shifts occurred between 1970 and 1990; downward shifts common in the 1990s.
  - Late 1990s / early 2000s upward shifts correlated with HIPC Initiative (launched 1996).
- Average magnitudes of shifts:
  - During upward shifts the aid-to-GDP ratio increases by 5.9 percentage points.
  - During downward shifts the aid-to-GDP ratio decreases by 7.1 percentage points.

### Determinants of shifts in aid dependency (marginal effects)
- Upward shifts (significant at 5% and 1% where noted):
  - GDP per capita:
    - An increase in per capita GDP by US$ 50 decreases the probability of an aid upward shift by 25 percent.
  - Natural resource rents:
    - An increase in natural rents by 1 percent of GDP decreases the probability of an aid upward shift by 14 percent.
  - IMF-supported programs:
    - Being under an IMF program increases the probability of experiencing an aid upward shift by almost 37 to 42 percent.
  - Market-oriented policies:
    - A one standard deviation increase in acceptance of market-oriented policies increases probability of an aid upward shift by 21 percent.
  - Diplomatic proximity:
    - A one standard deviation increase in diplomatic proximity with the United States increases probability of an aid upward shift by 40 percent.
    - A one standard deviation increase in diplomatic proximity with Russia increases probability of an aid upward shift by 28 percent.
- Downward shifts:
  - GDP per capita:
    - An increase of per capita GDP by US$ 50 increases the probability of an aid downward shift by 50 percent.
  - Diplomatic proximity:
    - A one standard deviation increase in political closeness with the United States reduces the probability of an aid downward shift by 63 percent.
    - A one standard deviation increase in political closeness with Russia reduces the probability of an aid downward shift by 57 percent.

### Fiscal effects of aid shifts — main findings (PSM estimates; bootstrapped SEs with 500 replications)
- General finding:
  - Upward shifts (large and sustained aid inflows) undermine tax capacity and public investment and increase current expenditure.
  - Downward shifts (significant reductions in aid inflows) tend to have no effect on fiscal ratios or the composition of revenues and spending except for current expenditure.
- Upward shifts (ATT, nearest-neighbor matching):
  - Tax revenue:
    - ATT = -2.2950***.
    - Experiencing an aid upward shift leads to a loss of about 2.3 percent of tax-to-GDP.
    - 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.
  - Capital expenditure:
    - ATT = -3.3260***.
    - Experiencing an aid upward shift yields a decrease in capital expenditure by about 3.3 percentage points of GDP.
    - Equivalent to a decrease in capital expenditure by about 0.6 percentage points for a one percentage increase in aid-to-GDP during upward shift episodes.
  - Current expenditure:
    - ATT = 6.3800*.
    - After an aid upward shift, current expenditure tends to increase by 6.4 percent of GDP.
    - Corresponds to an increase of current expenditure by about 1.1 percentage points for a one percentage increase in aid-to-GDP ratio.
  - Tax components (nearest-neighbor results):
    - Goods and Services revenue: ATT = -0.7705***.
    - Value Added Tax revenue: ATT = -0.7824*.
    - Income Tax revenue: ATT = -0.7238***.
    - Corporate Tax revenue: ATT = -0.4594***.
    - Trade Tax revenue: ATT = -0.3502 (not significant).
- Downward shifts:
  - Tax revenue:
    - ATT = 1.183 (not statistically significant).
    - No evidence of tax displacement for downward shifts.
  - Capital expenditure:
    - ATT ≈ -0.398 (not statistically significant).
    - Capital expenditure remains largely unaffected overall.
  - Current expenditure:
    - ATT ≈ -2.8390**.
    - After an aid downward shift, current expenditure is reduced by about 2.8 percent of GDP.
    - Equivalent to a decrease in current expenditure by about 0.5 percentage points for every one percentage decrease in the aid-to-GDP ratio during the downward shift episode.
  - Tax components (downward shifts):
    - Some asymmetric effects: downward shifts may reduce corporate income and goods and services tax revenues, but can increase trade tax revenue (e.g., trade tax ATT = 1.5203**).

### Dynamics: time-varying effects (4-year window; dynamic propensity score matching)
- Tax revenue — Upward shifts (ATT by year):
  - T1: -2.1753** (standard error (0.8401))
  - T2: -2.0380** (0.95)
  - T3: -1.6943 (1.1756)
  - T4: -1.5926 (1.2811)
- Tax revenue — Downward shifts (ATT by year):
  - T1: 0.9334 (0.9528)
  - T2: 0.7402 (0.9221)
  - T3: 0.6230 (0.8323)
  - T4: 0.5127 (0.8481)
- Interpretation for tax displacement:
  - The tax displacement effect of an aid upward shift decreases over time from 2.3 percent in T0 to 2.0 percent in T2 and vanishes after two years.
  - Aid downward shifts do not affect tax collection over time.
- Capital expenditure — Upward shifts (ATT by year):
  - T1: -3.3892*** (1.0912)
  - T2: -3.5271*** (0.8945)
  - T3: -3.851*** (0.9093)
  - T4: -4.0111*** (0.8431)
- Capital expenditure — Downward shifts (ATT by year):
  - T1: -0.5839 (1.2394)
  - T2: -0.8621 (1.2864)
  - T3: -1.6472 (1.1184)
  - T4: -2.1739** (1.0021)
- Interpretation for capital expenditure:
  - The negative effect of an aid upward shift on capital expenditure is persistent and increases over time, reaching about 4.0 percent of GDP at T4.
  - Aid downward shifts negatively affect capital expenditure starting from year T4.
- Current expenditure — Upward shifts (ATT by year):
  - T1: 6.3027* (3.472)
  - T2: 6.1414* (3.4504)
  - T3: 6.0646* (3.3822)
  - T4: 6.1094* (3.4412)
- Current expenditure — Downward shifts (ATT by year):
  - T1: -2.9487*** (1.1025)
  - T2: -2.7631** (1.0891)
  - T3: -2.4292** (1.1188)
  - T4: -2.0067* (1.1482)
- Interpretation for current expenditure:
  - The positive effect on current expenditure after an aid upward shift is persistent and around 6.5 percent of GDP (significant at only 10 percent) for at least four years.
  - Declines in current expenditure after aid downward shifts are persistent up to year T4.

### Heterogeneity: governance, absorptive capacity, and IMF programs
- Governance and absorptive capacity:
  - The tax displacement effect, the “aid illusion” effect on current expenditure, and reductions in capital expenditure after upward aid shifts are present only in countries with low governance scores and low absorptive capacity.
  - Aid downward shifts have fiscal effects only when the quality of governance is low; specifically, aid downward shifts reduce government expenditure (total, current, and capital expenditure) due to cuts in potential aid income.
  - Example numeric phrasing in source: "2.9 percent of GDP and capital expenditure when the recipient country has low governance score."
- IMF programs:
  - IMF-supported programs mitigate tax displacement from upward aid shifts.
  - Nearest-Neighbor matching ATT estimates for tax revenue:
    - IMF program subsample: ATT = -0.7479 (not statistically significant).
    - Non-IMF program subsample: ATT = -6.779***.
  - Interpretation: the adverse effect on tax collection of upward shifts is muted under IMF programs; tax displacement is larger when no IMF program is present.
- Absorptive capacity and governance interpretations:
  - Low absorptive capacity: aid undermines incentives to invest in domestic tax collection and diverts public investment into government consumption; unit costs for tax collection and investment rise.
  - Quality of governance results mirror absorptive capacity findings for upward shifts: poor governance amplifies negative fiscal effects of aid upward shifts.

### Robustness and additional checks
- Trimming factor sensitivity:
  - Base specification used trimming ε = 0.10 (minimum 5 years between segments).
  - Robustness check used trimming ε = 0.15 (minimum 8 years between segments).
  - Results reported as robust to the larger trimming factor.
- Double robustness and multi-valued treatment checks:
  - Additional robustness exercises include the double robustness method (Lunceford and Davidian (2004)) and multi-valued treatment effects; main findings hold.
- Selected robustness ATT estimates (Table 7):
  - Upward shifts — Tax revenue ATT: -3.0740*** (0.542)
  - Downward shifts — Tax revenue ATT: -2.2950*** (0.805)
  - Upward shifts — Capital expenditure ATT: -4.1890*** (1.146)
  - Downward shifts — Capital expenditure ATT: -3.3260*** (1.048)
  - Upward shifts — Current expenditure ATT: 1.0202** (0.4722)
  - Downward shifts — Current expenditure ATT: 6.3800* (3.385) and -5.3200*** (0.946) and -2.8390** (1.125) reported across robustness specifications
- Matching and balance diagnostics:
  - Matching estimator: Nearest-Neighbor matching estimator; bootstrapped standard errors based on 500 replications.
  - Common support and balance: Balance tests (probabilities of Chi(2)) do not reject covariate balance for upward and downward shifts across fiscal outcomes (e.g., Tax revenue 0.882 for upward shifts, 0.445 for downward shifts; Overall balance 0.372 upward, 0.943 downward).

### Policy implications and recommendations
- Aid inflows should be managed with caution, especially in countries with low governance or low absorptive capacity.
- Efforts and capacity building should focus on:
  - Maintaining or strengthening tax capacities in recipient countries.
  - Strengthening public investment implementation to avoid persistent crowding out of capital expenditure.
- When countries graduate from aid or face rationing of aid, policy focus could be on preserving current spending essential for inclusive growth (for example, well-targeted social programs).

*Source: _wp16112*

### References .............................................................................................................

### _wp16112 - References .............................................................................................................

### Methodology and data
- Study period: panel of 59 developing countries from 1960 to 2010.
- Identification strategy:
  - Structural shift model of Bai and Perron (1998, 2003) to identify shift years in aid dependency.
  - Probit model to explore determinants of upward and downward shifts in aid dependency.
  - Propensity score matching (PSM) methodology to assess fiscal effects of changes in aid dependency and to account for potential selection bias.
- Focus: static and dynamic impacts of shifts in aid dependency, including short- and long-term effects and exploration of non-linearities.

### Determinants of shifts in aid dependency
- Upward shifts (increases in aid dependency) are:
  - Less common as economic development of recipient countries improves.
  - Less common as natural resources rents increase.
  - More likely with acceptance of market-oriented policies.
  - More likely in the presence of an IMF program.
- Downward shifts (reductions in aid-to-GDP ratios) are:
  - More frequent as recipient countries develop.
  - More frequent when countries have fewer diplomatic ties with key international players (the United States or Russia).

### Fiscal effects of aid shifts — main findings
- Asymmetric effects:
  - Upward shifts (large and sustained aid inflows) undermine tax capacity and public investment.
  - Downward shifts (significant reductions in aid inflows) tend to have no effect on fiscal ratios or the composition of revenues and spending, except for current expenditure.
- Specific quantified effects reported:
  - Upward shifts induce a fall of about 2.3 percent in tax revenues as a share of GDP.
  - Upward shifts induce a fall of about 3.3 percent in capital expenditure in percent of GDP.
- Persistence and timing:
  - The tax displacement effect lasts only two years.
  - Impacts on expenditure items tend to be longer, at least five years.
- Composition effects:
  - Current expenditure increases with significant surges in aid inflows.
  - Current expenditure decreases with falls in aid inflows.
- Mechanisms documented:
  - Tax displacement effect (aid inflows undermine tax effort).
  - Investment displacement effect (aid inflows undermine public investment).
  - “Aid illusion” effect (aid inflows inflate current expenditure more proportionately).

### Heterogeneity: governance, absorptive capacity, and IMF programs
- The tax displacement effect, the “aid illusion” effect, and reductions in capital expenditure after upward aid shifts are present only in:
  - Countries with low governance scores.
  - Countries with low absorptive capacity.
- The tax displacement effect tends to be muted under IMF-supported programs.

### Robustness and contribution
- Results are robust to several alternative specifications.
- Novel contributions:
  - Focus on structural shifts in aid dependency rather than average-year effects.
  - Application of Bai and Perron structural shift model and PSM methodology in the aid literature.
  - Assessment of short- and long-term, asymmetric, and non-linear fiscal effects of aid shifts.

*Source: _wp16112 - References .............................................................................................................*

### Section III specifies our econometric estimation strategy, while Section IV describes our data

### _wp16112 - Section III specifies our econometric estimation strategy, while Section IV describes our data

### Overview of the literature
- Two broad themes in the literature on aid and fiscal accounts: (i) impact on tax effort and (ii) impact on expenditure.
- Aid and tax effort:
  - Aid may discourage domestic tax effort or substitute for domestic revenue (cited studies).
  - Evidence is mixed: some studies find negative impacts on tax revenues; others find positive or insignificant relationships.
- Aid and expenditure:
  - Aid is fungible: one additional dollar of aid can increase total government expenditure by less than one dollar; it can be fully fungible when government spending does not increase at all.
  - Existing literature documents fungibility for government expenditure components, but not the broader fiscal impact over time; this paper studies both expenditure and revenue sides.

### Econometric strategy
- Structural shift approach for identifying shifts in aid dependency:
  - Uses Bai and Perron multiple structural change tests (sequential testing for shifts).
  - Primary series: total aid in real terms; further judgment criteria: aid per capita and aid-to-GDP.
  - Definition of shifts:
    - “Upward shift” when both per capita aid and aid-to-GDP increase after a structural shift.
    - “Downward shift” when both per capita aid and aid-to-GDP decrease after a structural shift.
    - Ambiguous cases treated as non-events.
  - Trimming parameter ߝ =0.10 used; with sample period 1960-2010 each segment must contain minimum number of 5 years.
  - Sequential testing uses 0.10 significance level.
- Propensity Score Matching (PSM) approach:
  - Shifts (up or down) are treated as the treatment status.
  - Propensity score estimated via logit/probit conditional on observable covariates (selection model).
  - Matching methods used: (i) nearest neighbor matching; (ii) radius matching; (iii) Kernel matching; (iv) regression-adjusted local linear regression.
  - Propensity-score construction and matching ensure treated and control groups have similar initial conditions; outcomes compared as mean differences.
- Selection model covariates motivated by literature:
  - Economic development and macroeconomic performance (including IMF-supported program indicator).
  - Alternative financial resources (FDI, remittances).
  - Exploitation of natural resources (natural resource rents).
  - Quality of governance (CPIA index; later Polity2).
  - Exogenous shocks (natural disasters, conflict, terms-of-trade fluctuations).
  - Ideological/foreign policy considerations (market-orientation index; diplomatic proximity to United States and Russia).
- Aid-shift dummy constructed as 1 the year before, during, and after the Bai-Perron identified shift (3-year window); probit with year dummies used for estimation; controls lagged by one year.

### Dataset
- Panel of 59 countries covering 1960-2010; small countries with less than 1 million inhabitants excluded.
- Aid from OECD QWIDS measured as disbursements.
- Fiscal variables (tax revenue, capital and current expenditures) from IMF datasets; all expressed in percent of GDP.
- Controls from World Bank 2014 WDI: GDP per capita, GDP growth, public debt/GDP, FDI/GDP, remittances/GDP, trade openness, natural resource rents/GDP.
- Governance: CPIA index; Polity2 used later for democracy measure.
- IMF program, natural disaster, conflict dummies from IMF databanks, EM-DAT (CRED 2014), and Uppsala Conflict Data Program.
- Terms-of-trade shocks constructed via HP filter (smoothing parameter 6.25 for annual data).
- Market-orientation and diplomatic proximity indices from UN voting-based measures (Bailey, Strezhnev and Voeten 2013).

### Overview of shifts in aid dependency (summary statistics)
- Identified shifts (1960-2010):
  - 93 cases of upward shifts.
  - 48 cases of downward shifts.
  - 28 indeterminacies in which per capita aid increases but aid-to-GDP decreases.
- Unconditional annual probabilities:
  - Aid upward shift: 4 percent.
  - Aid downward shift: 2 percent.
- Regional distribution:
  - Africa: 64 upward-shift episodes and 34 downward-shift episodes.
  - Majority of upward shifts occurred between 1970 and 1990; downward shifts common in the 1990s.
  - Late 1990s / early 2000s upward shifts correlated with HIPC Initiative (launched 1996).
- Average magnitudes of shifts:
  - During upward shifts the aid-to-GDP ratio increases by 5.9 percentage points.
  - During downward shifts the aid-to-GDP ratio decreases by 7.1 percentage points.

### Determinants of aid shifts (main significant marginal effects)
- Upward shifts (significant at 5% and 1% where noted):
  - GDP per capita:
    - An increase in per capita GDP by US$ 50 decreases the probability of an aid upward shift by 25 percent.
  - Natural resource rents:
    - An increase in natural rents by 1 percent of GDP decreases the probability of an aid upward shift by 14 percent.
  - IMF-supported programs:
    - Being under an IMF program increases the probability of experiencing an aid upward shift by almost 37 to 42 percent.
  - Market-oriented policies:
    - A one standard deviation increase in acceptance of market-oriented policies increases probability of an aid upward shift by 21 percent.
  - Diplomatic proximity:
    - A one standard deviation increase in diplomatic proximity with the United States increases probability of an aid upward shift by 40 percent.
    - A one standard deviation increase in diplomatic proximity with Russia increases probability of an aid upward shift by 28 percent.
- Downward shifts:
  - GDP per capita:
    - An increase of per capita GDP by US$ 50 increases the probability of an aid downward shift by 50 percent.
  - Diplomatic proximity:
    - A one standard deviation increase in political closeness with the United States reduces the probability of an aid downward shift by 63 percent.
    - A one standard deviation increase in political closeness with Russia reduces the probability of an aid downward shift by 57 percent.

### Effects of aid shifts on fiscal accounts (PSM estimates; bootstrapped SEs with 500 replications)
- General finding:
  - Large and sustained aid inflows (upward shifts) are associated with reduced tax effort, higher current expenditure, and lower capital expenditure (as share of GDP).
  - Large reductions in aid inflows (downward shifts) have asymmetric effects: tax displacement not observed; current expenditure reduced; capital expenditure largely unaffected overall.
- Upward shifts (ATT, nearest-neighbor matching; robustness across matching methods reported):
  - Tax revenue:
    - ATT = -2.2950*** (statistically significant at 1%).
    - Experiencing an aid upward shift leads to a loss of about 2.3 percent of tax-to-GDP.
    - 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.
  - Capital expenditure:
    - ATT = -3.3260*** (statistically significant at 1%).
    - Experiencing an aid upward shift yields a decrease in capital expenditure by about 3.3 percentage points of GDP.
    - Equivalent to a decrease in capital expenditure by about 0.6 percentage points for a one percentage increase in aid-to-GDP during upward shift episodes.
  - Current expenditure:
    - ATT = 6.3800* (significant at 10%).
    - After an aid upward shift, current expenditure tends to increase by 6.4 percent of GDP.
    - Corresponds to an increase of current expenditure by about 1.1 percentage points for a one percentage increase in aid-to-GDP ratio.
  - Tax components (nearest-neighbor results):
    - Goods and Services revenue: ATT = -0.7705***.
    - Value Added Tax revenue: ATT = -0.7824*.
    - Income Tax revenue: ATT = -0.7238***.
    - Corporate Tax revenue: ATT = -0.4594***.
    - Trade Tax revenue: ATT = -0.3502 (not significant).
- Downward shifts:
  - Tax revenue:
    - ATT = 1.183 (not statistically significant across methods reported).
    - No evidence of tax displacement for downward shifts.
  - Capital expenditure:
    - ATT ≈ -0.398 (not statistically significant across methods reported).
    - Capital expenditure remains largely unaffected overall.
  - Current expenditure:
    - ATT ≈ -2.8390** (significant at 5% to 1% depending on method).
    - After an aid downward shift, current expenditure is reduced by about 2.8 percent of GDP.
    - Equivalent to a decrease in current expenditure by about 0.5 percentage points for every one percentage decrease in the aid-to-GDP ratio during the downward shift episode.
  - Tax components (downward shifts):
    - Some asymmetric effects: downward shifts may reduce corporate income and goods and services tax revenues, but can increase trade tax revenue (e.g., trade tax ATT = 1.5203**).

### Non-linear effects, IMF programs, absorptive capacity, and governance
- IMF-supported programs and tax displacement:
  - Splitting sample by IMF program participation shows IMF programs mitigate the tax displacement effect of upward aid shifts.
  - Nearest-Neighbor matching ATT estimates for tax revenue:
    - IMF program subsample: ATT = -0.7479 (not statistically significant).
    - Non-IMF program subsample: ATT = -6.779*** (statistically significant at 1%).
  - Interpretation: the adverse effect on tax collection of upward shifts is muted under IMF programs; tax displacement is larger when no IMF program is present.
- Absorptive capacity (index combining capacity constraints, governance constraints, and donor practices) and quality of governance (Polity2):
  - Sample split at median score (also tested with mean) shows:
    - The tax displacement effect of aid, the “aid illusion” effect on current expenditure, and the decline in capital expenditure after aid upward shifts are present only in low absorptive capacity countries.
    - When absorptive capacity is low, aid undermines incentives to invest in domestic tax collection and diverts public investment into government consumption; unit costs for tax collection and investment rise.
    - For downward shifts, low absorptive capacity is correlated with a decline in capital expenditure.
  - Quality of governance results mirror absorptive capacity findings for upward shifts: poor governance amplifies negative fiscal effects of aid upward shifts.

### Key implied conclusions
- Aid upward shifts are frequent and large in magnitude in developing countries, especially in Africa, and have important asymmetric fiscal effects.
- Large and sustained increases in aid:
  - Reduce tax-to-GDP (tax displacement).
  - Reduce capital expenditure as share of GDP (crowding out of public investment).
  - Increase current expenditure (aid illusion / consumption bias).
- Large reductions in aid:
  - Do not produce symmetric tax increases to offset past displacement.
  - Primarily reduce current expenditure; limited effect on capital expenditure and overall tax-to-GDP.
- IMF programs, better absorptive capacity, and higher quality of governance can mitigate negative fiscal consequences of aid inflows.

*Source: Authors, from _wp16112 - Sections II–IV and V–VI as provided in the source PDF.*

### 2.9 percent of GDP and capital expenditure when the recipient country has low governance

### 2.9 percent of GDP and capital expenditure when the recipient country has low governance score

### Summary findings on governance and absorptive capacity
- The tax displacement effect of aid, the “aid illusion” effect on current expenditure, and the decline in capital expenditure after aid upward shifts are present only in countries with low governance scores and low absorptive capacity.
- Aid downward shifts have fiscal effects only when the quality of governance is low; specifically, aid downward shifts reduce government expenditure (total, current, and capital expenditure) due to cuts in potential aid income.
- Aid upward shifts and aid downward shifts have asymmetric effects on fiscal accounts: large aid inflows undermine tax efforts and crowd out capital expenditure, while aid downward shifts reduce current expenditure.

### Time-varying effects of aid shifts (4-year window; dynamic propensity score matching)
- Tax revenue — Upward shifts (ATT by year):
  - T1: -2.1753** (standard error (0.8401))
  - T2: -2.0380** (0.95)
  - T3: -1.6943 (1.1756)
  - T4: -1.5926 (1.2811)
- Tax revenue — Downward shifts (ATT by year):
  - T1: 0.9334 (0.9528)
  - T2: 0.7402 (0.9221)
  - T3: 0.6230 (0.8323)
  - T4: 0.5127 (0.8481)
- Interpretation for tax displacement:
  - The tax displacement effect of an aid upward shift decreases over time from 2.3 percent in T0 to 2.0 percent in T2 and vanishes after two years.
  - Aid downward shifts do not affect tax collection over time.
- Capital expenditure — Upward shifts (ATT by year):
  - T1: -3.3892*** (1.0912)
  - T2: -3.5271*** (0.8945)
  - T3: -3.851*** (0.9093)
  - T4: -4.0111*** (0.8431)
- Capital expenditure — Downward shifts (ATT by year):
  - T1: -0.5839 (1.2394)
  - T2: -0.8621 (1.2864)
  - T3: -1.6472 (1.1184)
  - T4: -2.1739** (1.0021)
- Interpretation for capital expenditure:
  - The negative effect of an aid upward shift on capital expenditure is persistent and increases over time, reaching about 4.0 percent of GDP at T4.
  - Aid downward shifts negatively affect capital expenditure starting from year T4.
- Current expenditure — Upward shifts (ATT by year):
  - T1: 6.3027* (3.472)
  - T2: 6.1414* (3.4504)
  - T3: 6.0646* (3.3822)
  - T4: 6.1094* (3.4412)
- Current expenditure — Downward shifts (ATT by year):
  - T1: -2.9487*** (1.1025)
  - T2: -2.7631** (1.0891)
  - T3: -2.4292** (1.1188)
  - T4: -2.0067* (1.1482)
- Interpretation for current expenditure:
  - The positive effect on current expenditure after an aid upward shift is persistent and around 6.5 percent of GDP (significant at only 10 percent) for at least four years.
  - Declines in current expenditure after aid downward shifts are persistent up to year T4, though the crowding-out effect is smaller for current expenditure than for capital expenditure.

### Robustness checks
- Trimming factor sensitivity:
  - Base specification used trimming ε = 0.10 (minimum 5 years between segments).
  - Robustness check used trimming ε = 0.15 (minimum 8 years between segments).
  - Results are reported as robust to the larger trimming factor.
- Double robustness and multi-valued treatment checks:
  - Additional robustness exercises include the double robustness method (Lunceford and Davidian (2004)) and multi-valued treatment effects; main findings hold.
- Selected robustness ATT estimates (Table 7):
  - Upward shifts — Tax revenue ATT: -3.0740*** (0.542)
  - Downward shifts — Tax revenue ATT: -2.2950*** (0.805)
  - Upward shifts — Capital expenditure ATT: -4.1890*** (1.146)
  - Downward shifts — Capital expenditure ATT: -3.3260*** (1.048)
  - Upward shifts — Current expenditure ATT: 1.0202** (0.4722)
  - Downward shifts — Current expenditure ATT: 6.3800* (3.385) and -5.3200*** (0.946) and -2.8390** (1.125) reported across robustness specifications

### Policy implications and recommendations
- Aid inflows should be managed with caution, especially in countries with low governance or low absorptive capacity.
- Efforts and capacity building should focus on:
  - Maintaining or strengthening tax capacities in recipient countries.
  - Strengthening public investment implementation to avoid persistent crowding out of capital expenditure.
- When countries graduate from aid or face rationing of aid, policy focus could be on preserving current spending essential for inclusive growth (for example, well-targeted social programs).

### Key statistics and methodological notes
- Sample and period: 59 developing countries over 1960 to 2010 (shift points identified via Bai and Perron’s structural shift methodology).
- Matching estimator: Nearest-Neighbor matching estimator; bootstrapped standard errors based on 500 replications.
- Significance notation used in tables: ***p<0.01; **p<0.05; *p<0.10.
- Common support and balance: Balance tests (probabilities of Chi(2)) do not reject covariate balance for upward and downward shifts across fiscal outcomes (e.g., Tax revenue 0.882 for upward shifts, 0.445 for downward shifts; Overall balance 0.372 upward, 0.943 downward).

*Source: _wp16112 - 2.9 percent of GDP and capital expenditure when the recipient country has low governance score*

### REFERENCES

### REFERENCES

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### Aid, fiscal behavior, and public finance
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- Carter, P. (2013). Does foreign aid discourage taxation? Mimeo: Department of Economics, University of Bristol, Bristol, United Kingdom.
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- Clist, P, and O. Morrissey, (2011). Aid and Tax Revenue: Signs of a Positive Effect since the 1980s. Journal of International Development, Vol. 23, pp. 165-80.
- Franco-Rodrigez, S. (2000). Aid and the Public Sector in Pakistan: Evidence with Endogenous Aid. Journal of International Development, Vol. 12, pp. 429-441.
- Gupta, S, Clements, B, Pivovarsky, A. and Tiongson, E.R, (2003). Foreign Aid and Revenue Response: Does the Composition of Aid Matter? IMF Working Paper, WP/03/176. Washington, DC.
- Lloyd, T, McGillivray, M, Morrissey, O, and Opoku-Afari, M. (2009). The fiscal effects of aid in developing countries: A comparative dynamic analysis. In G. Mavrotas, and M. McGillivray (Eds.), Development aid: A fresh look (pp. 158-179). Basingstoke: Palgrave Macmillan UNU-WIDER Studies in Development Economics and Policy.
- Lu, C, Schneider, M, Gubbins, P, Leach-Keman, K, Jamison, D, and Murray, C. (2010). Public financing of health in developing countries: A cross-country systematic analysis. Lancet, Vol. 375, pp. 1375-1387.
- Martins, P.M.G, (2007). The impact of foreign aid on government spending, revenue and domestic borrowing in Ethiopia. International Poverty Centre working paper. Brasilia, Brazil.
- Martins, P.M.G, (2010). Fiscal dynamics in Ethiopia: A cointegrated VAR model with quarterly data: CREDIT research paper 10/05. University of Nottingham, School of Economics, Nottingham, United Kingdom.
- McGillivray, M, and O. Morrissey (2000). Aid illusion and public sector fiscal behavior. CREDIT Research Paper 00/9, University of Nottingham. Nottingham, United Kingdom.
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- McGillivray, M, and Morrissey, O. (2004). ‘Fiscal effects of aid. In T. Addison, and A. Roe (Eds.), Fiscal policy for development (pp. 72-96). Basingstoke: Palgrave/WIDER, Helsinki, Finland.
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### Aid allocation, donor behavior, and selectivity
- Alesina, A. and B. Weder (2002). Do corrupt governments receive less foreign aid? American Economic Review, Vol. 92(4), pp. 1126-37.
- Alesina, A, and D. Dollar (2000). Who gives foreign aid to whom and why? Journal of Economic Growth, Vol. 5 (1), pp. 33-63.
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- Claessens, S, D. Cassimon and B. van Campenhout (2009). Evidence on changes in aid allocation criteria. World Bank Economic Review, Vol. 23 (2), pp. 185-208.
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- Neumayer, E. (2003a). The Determinants of Aid Allocation by Regional Development Banks and United Nations Agencies. International Studies Quarterly, Vol. 47 (1), pp. 101-122.
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### Aid, growth, and private investment
- Burnside, C. and Dollar, D. (2000). Aid, polities, and growth. American Economic Review, Vol. 90(4). pp. 847-68.
- Collier, P. and Dehn, J. (2001). Aid, shocks and growth. World Bank Working Paper 2688, The World Bank, Washington, DC.
- Harms, P, and Lutz, M. (2006). Aid, governance and private foreign investment: Some puzzling findings for the 1990s. The Economic Journal, Vol. 116 (513), pp. 773-790.
- Hausmann R, Pritchett L, Rodrick D, (2005). Growth Accelerations. Journal of Economic Growth, Vol. 10, pp. 303-329.
- Donaubauer, J, Herzer, D, and Nunnenkamp, P. (2014). Does Aid for Education Attract Foreign Investors? An Empirical Analysis for Latin America. European Journal of Development Research, Vol. 26, pp. 597-613.
- Bhavan, T, C. Xu, C. Zhong (2011). The Relationship between Foreign Aid and FDI in South Asian Economies. International Journal of Economics and Finance, Vol. 3, No 2, pp. 143-149.

### IMF programs, conditionality, and donor catalysis
- Bulir, A. and S. Moon (2003). Do IMF-Supported Programs Help Make Fiscal Adjustment More Durable? IMF Working Paper WP/03/38. Washington, D.C.
- Cho, H. J. (2009). Do IMF Programs Discipline Budget Deficit? The Effects of IMF Programs on Government Budget Balance, Expenditures and Revenue. The Korean Journal of International Relations, Vol. 49 (6), pp. 7-33.
- Crivelli, E. and S. Gupta (2014). Does conditionality in IMF-supported programs promote revenue reform? IMF Working Paper WP/14/206. Washington, DC.
- Gündüz, Y. B. and M. Crystallin (2014). Do IMF-Supported Programs Catalyze Donor Assistance to Low-Income Countries? IMF Working Paper WP/14/202. Washington, DC.

### Aid effectiveness, absorptive capacity, and sectoral impacts
- Feeny, S. and A. de Silva (2012). Measuring absorptive capacity constraints to foreign aid. Economic Modelling, Vol. 29, pp. 725-733
- Feeny, S. and M. McGillivray (2011). Scaling-up Foreign Aid: Will the ‘Big Push’ Work. The World Economy, Vol. 34, pp. 54-73
- Pettersson, J. (2007). Foreign sectoral aid fungibility, growth and poverty reduction. Journal of International Development, Vol. 19 (8), 1074-1098.
- Van de Sijpe, N. (2013). Is foreign aid fungible? Evidence from the education and health sectors. World Bank Economic Review, Vol. 27(2), pp. 320-356.
- Lu, C, Schneider, M, Gubbins, P, Leach-Keman, K, Jamison, D, and Murray, C. (2010). Public financing of health in developing countries: A cross-country systematic analysis. Lancet, Vol. 375, pp. 1375-1387.

### Conflict, disasters, and humanitarian aid
- de Ree, J. and Nillesen, E. (2009). Aiding Violence or Peace? The Impact of Foreign Aid on the Risk of Civil Conflict in Sub-Saharan Africa. Journal of Development Economics, Vol. 88 (2), pp. 301-313.
- Strömberg, D. (2007). Natural Disasters, Economic Development, and Humanitarian Aid. Journal of Economic Perspectives, Vol. 21, pp. 199-222.
- Yang, D. (2008). Coping With Disaster: The Impact of Hurricanes on International Financial Flows. B.E. Journal of Economic Analysis and Policy, Vol. 8 (1), pp. 1-43.
- Dobronogov, A. and O. Keutiben (2014). Containing Volatility: Windfall Revenues for Resource-Rich Low-Income Countries. Policy Research Working Paper 6956, The World Bank. Washington, DC.

### Data sources, datasets, and project documentation
- Jarstad, A, D. Nilsson and R. Sundberg (2012). The IMPACT (Implementation of Pacts) Dataset Codebook, Version 2.0, Department of Peace and Conflict Research, Uppsala University, available at http://www.pcr.uu.se/data/. Accessed on June 2015.
- World Bank. (2014). World Development Indicators. Accessed on June 2015. http://databank.worldbank.org/data/reports.aspx?source=world-development-indicators
- Marshall, M. G, T. R. Gurr and K. Jaggers (2012). Political Regime Characteristics and Transitions, 1800-2012. Polity IV Project.

*Source: _wp16112 - REFERENCES*

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