What Does Aid Do to Fiscal Policy? New Evidence

By Jean-Louis Combes, Rasmané Ouedraogo, Sampawende J Tapsoba

June 9, 2016

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Jean-Louis Combes, Rasmané Ouedraogo, and Sampawende J Tapsoba. What Does Aid Do to Fiscal Policy? New Evidence, (USA: International Monetary Fund, 2016) accessed November 8, 2024

Disclaimer: This Working Paper should not be reported as representing the views of the IMF.The views expressed in this Working Paper are those of the author(s) and do not necessarily represent those of the IMF or IMF policy. Working Papers describe research in progress by the author(s) and are published to elicit comments and to further debate

Summary

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.

Subject: Absorptive capacity, Balance of payments, Capital spending, Current spending, Expenditure, Foreign aid, Revenue administration

Keywords: Absorptive capacity, Africa, Aid illusion, Capital spending, Crowding out, Crowding-out effect, Current spending, Displacement effect, Exchange Rate, Fiscal policy, Foreign aid, Fungibility, Global, IMF program, Recipient country, South Asia, Sub-Saharan Africa, Tax displacement effect, Tax revenue, Treatment effect approach, Treatment effect literature, WP

Publication Details

Pages:

32
Volume:

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DOI:

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Issue:

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Series:

Working Paper No. 2016/112
Stock No:

WPIEA2016112
ISBN:

9781484382691
ISSN:

1018-5941

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