Aid and Public Finance: A Missing Link?

Article excerpt

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. …