Fiscal; Impact; Aid; Flows; Evidence; Ethiopia; Poverty

Pedro M. G. Martins

English

Research Papers in Economics

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      September, 2007      Number  43
by Pedro M. G. Martins,
Visiting IPC Researcher,  Institute for Development Studies, Sussex
The Fiscal Impact of Aid Flows:
Evidence from Ethiopia
Foreign aid flows to developing countries have increased
considerably in the last decade. This trend is driven mostly by the
need to meet the resource gap in countries committed to fight
poverty and achieve the Millennium Development Goals (MDGs).
In sub-Saharan Africa, where aid inflows account for a significant
share of GDP, the fiscal impact of aid is fundamental to assessing
its effectiveness. This One Pager seeks to contribute to the debate
on aid by presenting results from a traditional fiscal response
model estimated for Ethiopia.
The model focuses on the impact of foreign aid on government
expenditure, revenue and domestic borrowing. Fiscal data for
1964-2005 were obtained from the IMF’s International Financial
Statistics (IFS) database and complemented by secondary sources.
A summary of the results is presented in the table, with aid
disaggregated into its two main components, grants and loans.
The coefficients denote foreign aid’s total impact on the remaining
fiscal variables, over the period under consideration.
The results suggest that foreign aid to Ethiopia has had a positive
impact on government capital expenditure, but not a significant
effect on recurrent spending (the coefficients are virtually zero).
Moreover, aid loans seem to have had a stronger impact on
government expenditure than grants, particularly on capital
spending (with a coefficient of 0.30 for loans versus 0.06 for grants).
These findings are not entirely surprising since aid flows
(especially loans) are often earmarked to specific investment
projects, while governments are likely to use domestic tax
revenues to pay for most recurrent costs.
Interestingly, both aid grants and loans have had a strong
negative effect on domestic borrowing. This suggests that aid
and domestic financing are close substitutes. There are two
possible interpretations for this relationship. Since domestic
borrowing is often an expensive last resort to balance the budget,
an increase in aid flows could be used to reduce such a burden.
Conversely, it might also be the case that, facing a shortfall in
aid flows, the government seeks domestic finance to keep
expenditure levels stable.
The results also seem to support the hypothesis that aid displaces
domestic revenue. Note the negative coefficient for loans (-0.15)
but the even larger one for grants (-0.47). This raises concerns
about how low-income countries, such as Ethiopia, can eventually
overcome aid dependence.
However, these results might also be capturing some indirect effects,
such as those due to aid conditionality. Aid flows to Ethiopia
increased substantially from the early 1990s, roughly coinciding
with the start of economic reforms that were designed to reduce
public spending and reform the tax system (such as lowering rates).
This might partly explain the apparent weak impact of aid on
spending and the negative correlation with domestic revenue.
In conclusion, the results suggest that donors and recipients
of aid should focus on ensuring greater ‘aid additionality’.
The priority should be on financing new capital spending, which
can contribute not only to enhancing human development but
also to expanding the economy’s productive capacity.
While using foreign aid to pay off onerous domestic debt can
serve a useful purpose at least in the short run, the medium-term
purpose of aid should clearly be to expand MDG-related
government spending.
Most troubling is the apparent displacement of domestic revenue
by aid flows. One implication is that donors should channel more
aid precisely into building up national capacities to mobilise
domestic revenue. Otherwise, developing countries such as Ethiopia
will have difficulty in graduating from heavy reliance on external aid.
Reference:
1. Martins, Pedro  M. G. (2007). ‘The Impact of Foreign Aid on the Government Sector: The Case
of Ethiopia’, forthcoming IPC Working Paper, Brasilia.
   The Fiscal Impact of Aid in Ethiopia, 1964-2005
Source: Martins (2007).
1
Grants 0.06 0.00 -0.47 -0.44
Loans 0.30 0.03 -0.15 -0.46
Domestic
Borrowing
Capital
Spending
Recurrent
Spending
Domestic
Revenue

The Fiscal Impact of Aid in Ethiopia, 1964-2005 Source: Martins

The Impact of Foreign Aid on the Government Sector: The Case of Ethiopia’, forthcoming IPC Working Paper,

The Fiscal Impact of Aid Flows: Evidence from Ethiopia

http://www.ipc-undp.org/pub/IPCOnePager43.pdf

The Fiscal Impact of Aid Flows: Evidence from Ethiopia

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