The Impact of Aid on Total Government Expenditures: New Evidence on Fungibility

Abstract

Foreign aid’s effectiveness remains one of the most debated topics in development economics. This thesis investigates an important channel of the impact of aid on the recipient country’s economy: the government’s fiscal response to aid. Firstly, the impact of total aid, of onand off-budget aid, and of bilateral and multilateral aid on government expenditures and revenues is estimated. Secondly, this thesis explores instrumental variable methods that have been used to account for potential endogeneity of aid in these regressions. Thirdly, the causal links between government expenditures and on-budget aid are analyzed. Aid is found to partially increase government expenditures, which indicates that governments adjust domestic revenues or net borrowing in response to aid. This suggest that aid’s impact on development indicators is a sum of increased spending, increased private consumption and savings, and potential improvements in the structure and quality of government expenditures due to donor involvement.