DP5721 | Foreign Aid and Fiscal Policy

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Publication Date

23/06/2006

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Abstract

Foreign aid has been on a downward trend since at least the early eighties. Despite the commitments of donor governments, the GDP share of foreign aid for DAC countries has fallen to slightly more than 0,2% in the early part of this decade. The purpose of this paper is to explore the macro determinants of the amount of foreign aid. Surprisingly enough, not much attention has been devoted in the literature to this issue. Most of the research has focussed either on the effectiveness of aid (?does aid promote growth and help alleviating poverty??) or to the cross country allocation of a given amount of foreign aid (?is foreign aid motivated by donor?s political and commercial interests or by recipients? needs??). In both cases, the total aid budget is taken as given and its determinants remain therefore unexplored. Our main finding is that the size of the budget aid is a function of the donor country?s fiscal situation, even after controlling for the government?s political orientation, the cyclical position of the donor economy, and its income per capita level. In light of these results, we argue that advocates of foreign aid should strongly lobby in favour of fiscal discipline. The alternative strategy of pushing for a more lenient budgetary treatment of foreign aid may be loaded with risks, and even turn to be counterproductive, particularly if the list of ?virtuous? exceptions becomes exceedingly long. This is exactly what seems to have happened with the revision of the Stability and Growth pact.