DP10802 | Taxing Fragmented Aid to Improve Aid Efficiency

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We present a model with two donors-principals that provide funds to a unique recipient-agent. Each donor decides how to allocate his aid funds between a pooled and a donor specific unilateral project. The production function of development depends positively on the three inputs (pooled funds and each unilateral project). They are complement in the sense that the development good is only produced if a minimum of each of these inputs is provided. Both principals and the agent value the output produced with the principals' pooled and two unilateral funded projects. However the donors have a bias in favor of their own unilateral project, which leads them to over-invest in these projects compared to the investment in the pooled project. The contributions to unilateral projects are greater than the welfare maximizing levels. To correct this problem the agent establishes a tax on the implementation of unilateral projects, which acts as a protection measure against biased allocation by the principals. The optimal tax imposed by the recipient on unilateral projects varies depending on the total amount of aid provided by the donor and on the productivity of his unilateral project. We present empirical support on the donors' preferences for unilateral projects, and how allocations and fragmentation are affected by recipient's characteristics.