Aid and Public Finance: A Missing Link?

Beginning of article

Introduction

Findings in recent publications generally agree that foreign aid does not have the desired positive effect on growth and poverty alleviation. The two main reasons for this seem to be political patterns of aid-flows and poor performance of recipient countries' public institutions (Alesina and Dollar 2000).

We investigate the relationship between the Quality of Public Financial Institutions (PFI quality) of less developed countries, and the level of multilateral aid they receive. This raises two central sets of questions:

First, does PFI quality develop in reaction to multilateral aid received? If such a relationship exists, will it be positive or negative; i.e., does multilateral aid foster or hinder public finance quality and thereby good governance and institutional development?

Second, do multilateral aid-flows move relative to the recipient country's PFI quality? If so, does empirical evidence suggest that multilateral donors regard improvements in PFI quality as an incentive (or condition) to increase aid-giving? Or could there be the case that recipient countries with poor institutions attract more aid?

This paper uses empirical evidence, in the form of panel data on 86 countries over a 19 year period, to answer the questions above. Apart from a set of robust econometric specifications, our research also requires the construction of a coherent measure of PFI quality. For this purpose we set up a new Public Financial Institution Quality (PFIQ) Index, which draws from standardised assessments of institutional quality, as well as from reliably available national data.

We restrict our investigation to multilateral aid-giving, as its underlying decisions should be free from political and strategic motives (Alesina and Dollar 2000). Multilateral aid is defined as foreign aid donations from the following: African Development Bank, African Development Fund, Asian Development Bank, Asian Development Fund, European Commission, International Bank for Reconstruction and Development, International Development Association, InterAmerican Development Bank, Inter-American Development Bank Special Fund, International Fund for Agricultural Development, United Nations Development Program, United Nation's Children's Fund, Joint United Nations Programme on HIV/AIDS, United Nations Population Fund, and the Global Fund.

Literature Review

The bulk of existing literature on foreign aid is divided into two sections. One section studies the effects of foreign aid on the recipient country's institutions and governance, and the other studies the impact of changes in institutions and governance on aid-flow patterns.

Concerning the effects of foreign aid on recipient country's institutions, Boone (1996) argues that aid does not cause an increase in investment or improve human development indicators, but it does increase the size of government. Similarly, Burnside and Dollar (2000) estimate an equation for government consumption as a share of GDP, and find that aid has a strong positive impact on government consumption. Both studies suggest that aid does have an effect on governmental institutions, but that these changes, in turn, seem not to positively translate into growth and poverty alleviation. This puzzle suggests that the black box of governance in developing countries is not working effectively. This may be due to misguided incentives and rent-seeking behavior or to chronic institutional inabilities--both of which are related to PFI quality.

In their 2000 paper, Alesina and Dollar find that exogenous changes in aid have no impact on recipient countries' levels of democratization. On the same note, Burnside and Dollar (2000) argue that aid has no substantial effect on economic policies. Assuming that institutional variables such as democratization and economic policies are closely intertwined with PFI quality (because of positive externalities or spill-over effects), these findings suggest that aid may not have any significant impact on PFI quality.

Knack (2001) finds that higher aid levels erode the quality of governance, which he measures by bureaucratic quality, rule of law, and corruption. Alesina and Weder (2002) furthermore provide tentative evidence of increases in aid being correlated with increases in corruption. On a similar note, Brautigam and Knack (2004) find that higher levels of aid are associated with lower tax effort (defined as the ratio of tax revenue to GDP). These findings suggest a negative relationship between aid and PFI quality, of which governance quality and tax effort are indicative measurements.

Few findings do suggest a positive correlation between targeted foreign aid and government institution quality. In our case of interest, aid is sometimes used for improved training and increased salaries for public employees, including judges and tax collectors. Van Rijckeghem and Weder (2001) argue that because of the increase in salaries, more competent bureaucrats can be employed and bribe solicitation can be reduced, thereby dissuading rent-seeking behavior. The result will be an improvement in tax effort and government creditworthiness, which would both provide support for the country's PFI quality.

With respect to the impact of institutional and governance changes on aid, Alesina and Dollar (2000), and Knack (2001) point out that, at the margin, institutional factors and democratization do attract aid, even though political considerations on the donors' behalf do play a significant role. These results hint at a possible positive response of multi-lateral aid to PFI quality improvements.

An interesting, though contested, finding by Burnside and Dollar (2000) asserts that aid raises growth in a good policy environment. However, Easterly et al. (2004) show that these results are not robust to the use of additional data.

Despite questionings concerning the strength of their empirical findings, Burnside and Dollar's underlying theory finds resonance in other publications. Boone (1996), for example, shows that aid targeted to liberal regimes may be more successful in alleviating social misery. In a similar fashion,

Brautigam and Knack (2004) reason that Sub-Saharan Africa's development problems ultimately reflect a crisis of governance, and argue that only aid provided on a more selective basis can trigger a virtuous cycle of development.

On the assumption that multilateral aid-flows are purpose-bound and designed to serve effective growth rather than political strategies, the findings cited above suggest that multilateral aid should be attracted towards democratization, liberal regimes, and sound economic policies. Granted that these three variables are reflected in good PFI quality, donors should either reward or condition aid on improvements in recipient countries' public finance systems.

A puzzling result from Alesina and Weder (2002) is that multilateral donors seem not to take account of a recipient nation's degree of corruption when allocating aid. In contrast to this, Burnside and Dollar (2000) find that multilateral aid is allocated in favor of good policy. These contradictory findings, then, do not yield clear-cut assumptions on the relationship between PFI quality and aid.

The next section argues why we chose to focus on public finance systems; thereafter, we discuss the empirical equations we put to use and our methods of investigation. The section that follows explains how we constructed the PFIQ Index. This section is then succeeded by a summary of our data sources and our methods of compilation. Based on this, we outline the various regression specifications and the identification strategies used, and then we follow with sections that detail the results for PFIQ regressions and aid regressions. Finally, we provide a summary of caveats and a conclusion.

The Case for Public Finances

The quality of public finance is determined by the level and composition of public expenditure and its financing via revenue and deficits. An ECB working paper (Afonso et al. 2005) finds that high quality public finances support the long-run growth of the economy. Specifically, low deficits and debt ratios create expectations that public finances are sustainable, so that expenditure policies and tax systems and rates will be predictable. This supports economic growth because it creates an environment conducive to long-term oriented savings and investment decisions. By contrast, if, over a longer period, government revenue is much lower than total public spending--creating unsustainable macro imbalances and public debt accumulation--growth may be reduced because the private sector might come to see the fiscal situation as unsustainable and reduce investment in anticipation of future higher taxes.

Public finance systems have received increased attention in the donor community. In 2005, more than 100 countries and donor organizations recognized the imperative of managing aid more rationally when they endorsed the Paris Declaration on Aid Effectiveness. A cornerstone of the plans to reform the system of aid delivery was to strengthen and use country systems, that is; use the national government circuits of public finance rather than by-pass these circuits to deliver aid to citizens. Donors agreed to concede that the degree to which they relied on recipient country's public finance systems depended at least partly on the quality of these systems, and that progress will depend on greater understanding of the development benefits and risks of using these systems, l The motivation for this paper is inscribed directly in the line of this last citation.

Despite this increased interest, no index in the academic circles has yet been constructed. In parallel to the Paris Declaration, …