What Does Aid Do to Fiscal Policy? New Evidence

IMF Working Papers, June 9, 2016

Source details

Study revisits fiscal effects of shifts in aid dependency in 59 developing countries from 1960 to 2010.
Identifies structural shifts in aid dependency: upward shifts (structural increases in aid inflows) and downward shifts (structural decreases in aid inflows).
Treats these structural shifts as shocks in aid dependency and uses treatment effect methods to assess fiscal effects of aid.

Sample: 59 developing countries.
Time period: 1960 to 2010.
Analytical approach: identification of structural upward and downward shifts in aid dependency; treatment effect methods to estimate fiscal impacts.

Shifts in aid dependency are frequent and have significant fiscal effects.
Evidence of traditional phenomena:
- Tax displacement.
- “Aid illusion.”
Asymmetric effects:
- Upward shifts (large aid inflows) undermine tax capacity and public investment.
- Downward shifts (large reductions in aid inflows) tend to leave recipients’ tax and expenditure ratios unchanged.
Persistence and temporality:
- Tax displacement effects tend to be temporary.
- Impacts on expenditure items are persistent.
Conditional effects:
- Undesirable fiscal effects of aid are more pronounced in countries with low governance scores.
- Effects are more pronounced in countries with low absorptive capacity.
- Effects are more pronounced in countries 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