Closing the Gap: A LIC’s Policy Options Under an Aid Shock

IMF Working Papers, July 17, 2026

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The paper uses a structural model calibrated to an aid-dependent economy to analytically explore the macroeconomic and distributional effects of a permanent aid cut under three alternative policy responses: non-concessional borrowing, domestic revenue mobilization, and uncompensated spending cuts.
A borrowing-only response leads to unsustainable debt and highly regressive outcomes.
An uncompensated spending cut results in economic stagnation, higher poverty, and adverse inequality.
A strategy combining moderate borrowing with ambitious domestic revenue mobilization, while painful in the medium term, produces the most favorable path to fiscal sustainability and moderates the rise in poverty and inequality.
Findings are analytical and model-based; they illustrate trade-offs inherent in fiscal adjustment under aid dependence rather than prescribing specific policy actions.

Non-concessional borrowing
- Outcome: unsustainable debt trajectory.
- Distributional impact: highly regressive outcomes.
Domestic revenue mobilization
- When combined with moderate borrowing: produces the most favorable path to fiscal sustainability and moderates increases in poverty and inequality.
- Characterized as ambitious and painful in the medium term within the model.
Uncompensated spending cuts
- Outcome: economic stagnation.
- Distributional impact: higher poverty and adverse inequality.

Method: structural model calibrated to an aid-dependent economy.
Purpose: to analytically explore macroeconomic and distributional effects of a permanent aid cut under alternative policy responses.
Nature of results: model-based illustrations of trade-offs, not prescriptive policy prescriptions.

Authors: Dawit Tessema, Sotima J Koussere
Date: July 17, 2026
Series: Working Paper No. 2026/151
Volume: 2026
Issue: 151
Pages: 52
DOI: https://doi.org/10.5089/9798229053518.001
ISBN: 9798229053518
ISSN: 1018-5941
Subjects: Expenditure, Income, Income distribution, Income inequality, National accounts, Public investment spending
Keywords: Aid Dependence, aid shock, Distributional Analysis, Domestic Revenue Mobilization, Fiscal Adjustment, IMF working papers, Income, Income distribution, income growth, Income inequality, Public investment spending, Sotima Jocelyn Koussere

IMF Working Paper — Closing the Gap: A LIC’s Policy Options Under an Aid Shock