Foreign Aid Effectiveness: Evidence from Panel Data Analysis

Abstract

The effectiveness of foreign aid is an important issue that encompasses a wide range of academic fields but fails to provide any underlying consensus. This study empirically investigates the effectiveness of foreign aid in reducing income inequality of the developing world and subsamples of countries from Africa, South Asia, and South America, which historically demonstrate socioeconomic and geopolitical similarities. In an attempt to recognize aid effectiveness with clarity, this study contributes to the debate in the literature to reconcile the seemingly composite effect of foreign aid on income inequality and extrapolate if the inhibitory mechanisms of institution quality have a regressing effect. Thus, central to the thesis are two intertwining legacies: (a) the possible egalitarian effect of foreign aid on the income distribution of a country and (b) aid effectiveness when a country’s institutional quality is factored in. Using panel data from eight subsamples, the study found statistically significant but marginal foreign aid effectiveness in tackling the income inequality divide of most developing countries. Moreover, the effectiveness diminishes when institutional quality is factored in, which implies a confounding yet deracinating effect on foreign aid efficacy.