Why do donor countries give foreign aid? The answers found in the literature are: (i) because donor countries care for recipient countries (e.g. altruism), and/or (ii) because there exist distortions that make the indirect gains from foreign aid (e.g. terms of trade effects) to be larger than the direct losses. This paper proposes a third answer to the above question, namely that aid is determined through the domestic political process of the donor country. The paper demonstrates how foreign aid affects the donor country’s income distribution and how, in a direct democracy, the majority of voters might benefit from foreign aid giving even though the country’s social welfare is reduced.

Pascalis Raimondos-Møller

Wolfgang Mayer

English

Research Papers in Economics

March 2, 1999
The Politics of Foreign Aid*
by
Wolfgang Mayer
Department of Economics, University of Cincinnati
and
Pascalis Raimondos-Møller
Department of Economics, Copenhagen Business School
and
Economic Policy Research Unit, University of Copenhagen
Abstract
Why do donor countries give foreign aid?  The answers found in the literature are:
(i) because donor countries care for recipient countries (e.g. altruism), and/or (ii)
because there exist distortions that make the indirect gains from foreign aid (e.g.
terms of trade effects) to be larger than the direct losses.  This paper proposes a
third answer to the above question, namely that aid is determined through the
domestic political process of the donor country.  The paper demonstrates how
foreign aid affects the donor country’s income distribution and how, in a direct
democracy, the majority of voters might benefit from foreign aid giving even
though the country’s social welfare is reduced.
JEL Classification:  F35
Keywords:  foreign aid, politics, majority voting.
Mailing Address: Pascalis Raimondos-Møller, Department of Economics, Copenhagen
Business School, Nansensgade 19, 5th floor, DK-1366 Copenhagen K., Denmark. Fax:
(+45) 3815 2665, Email: prm.eco@cbs.dk
_____________
* Raimondos-Møller’s research was funded by a grant from the Danish National Research
Foundation.  Mayer’s research was supported by EPRU and the Taft Memorial Fund of the
University of Cincinnati.1
1.  Introduction
Recently there has been renewed interest in the reasons and effects of
foreign aid.  The work of Boone (1996), Burnside and Dollar (1997), and
Alesina and Dollar (1998) analyses foreign aid flows for a large number of
years and countries and tests a number of hypotheses concerning the
effectiveness of aid, the allocation of aid between different recipient
countries, the motives for giving aid, etc.  These papers’ results provide
answers to the many questions that have been put forward in the extensive
literature on the economics of foreign aid.
Research on political explanations of foreign aid has centered
either on the international political interests of the donor government
(defense, political influence, etc.) or on the domestic political behavior of
the recipient government (democracy vs. dictatorship, fungibility of aid,
corruption, etc.).  The above- mentioned authors examine in detail whether
the data can identify these kinds of political-economy relationships.  What
has not been addressed in the literature, however, is the question of
domestic politics of the donor country in determining foreign aid flows.
Given the recent proliferation of political-economy explanations for a
country’s economic policy choices (see Rodrik (1995) for a comprehensive
survey and Dixit (1996) for a convincing justification for this approach ), it
seems most relevant to examine the domestic politics of foreign aid
determination.  The objective of this paper is to draw attention to the
political process in the donor country as a pivotal force in deciding whether
to give foreign aid.
1
In motivating our interest in finding political economy
explanations for foreign aid, it is worth recalling what we already know
from the literature on international income transfers (see Kemp (1992) for a
survey).  A well-established result is that in a two-country world the donor
of foreign aid becomes worse off if markets are undistorted and stable.
Hence, a country that chooses its economic policies with the objective of
                                                       
1 Similar issues are addressed in Lahiri and Raimondos-Møller (1999).  There,
however, the main point of interest is the allocation of aid between recipient
countries and how it is influenced by lobbying activities of  minority groups.2
maximizing social welfare would never wish to become a foreign-aid
donor.  The natural question raised then is how can one explain foreign aid
flows?
The answer offered by the trade literature focuses entirely on the
existence of distortions: given that markets face a number of distortions
(domestic or international, static or dynamic, endogenous or exogenous), it
is not unlikely that a transfer of income from one country to another will
create indirect benefits to the donor country that are larger than the initial
direct losses.  Donor governments are assumed to be aware of the size of
these indirect (perhaps long-term) gains and, given that they maximize
social welfare, it might be optimal for them to provide some positive
amount of foreign aid.  In this sense, the thrust of the argument is based on
standard second-best intuition.
2
A different type of explanation for the existence of foreign aid
flows is usually suggested by development economists.  Foreign aid is
given because donor countries are (and should be) altruistic.  This strand of
the literature focuses on showing that donor countries in reality help less
than what they think they do.  This argument is based on the negative
welfare effects that conditionality rules impose or on the adverse
behavioral changes that aid leads to (either by reducing the savings ratio or
by inducing delays in necessary political and economic reforms); see, e.g.,
Cassen (1988).  However, and returning to the question posed above,
giving aid is nothing else than the outcome of a donor’s country’s social
preference.
The present paper puts forward a quite different explanation of
foreign aid giving, namely that it is the outcome of the donor country’s
domestic political process.  Foreign aid, as any actual economic policy
choice, is determined through a political process in which all participants
pursue their self-interest rather than through the objective of maximizing a
country’s overall welfare.  The political process can result in foreign aid
giving if at least some people benefit from the country’s role as a donor.  If3
the beneficiaries from foreign aid giving are also decisive for the choice of
economic policies, then the country becomes a donor.  At issue, therefore,
is whether the giving of aid to foreign residents can benefit some segments
of the domestic population and whether the political process enables these
winners to impose their will on the rest of society.
The main idea of this paper is developed in a standard two-country,
two-good, two-factor framework in which political decisions on foreign aid
are made through majority voting.  Individuals have different factor
endowments and, therefore, different interests in economic policies.
Foreign aid is financed through a proportional income tax that is already in
place.  Foreign aid, therefore, reduces every person’s income and this direct
effect of foreign aid makes every person worse off.  There exist, however,
important indirect effects as well.  When foreign aid leads to a terms of
trade change, individuals are affected both as consumers and recipients of
factor income.  If each individual owned exactly the same amount of
factors of production, then the standard transfer payment result would
prevail, namely that the direct effect is always stronger than the indirect
effects and each person of the donor country becomes worse off.  If, on the
other hand, the distribution of factor ownership is unequal, then the indirect
effects of foreign aid might not only have a positive impact on a person’s
welfare but be sufficiently strong to more than offset the negative impact of
the direct effect.  Hence, some people might actually gain from the
country’s giving of foreign aid.  In a direct democracy with majority
voting, the median voter’s preferences are decisive for the policy choice.
3
If the median voter gains from the giving of aid, the country becomes a
                                                                                                                                                          
2 This intuition can also be applied to the so-called three-agent transfer problem, as
discussed in Bhagwati et. al. (1983).
3 We employ the direct-democracy, majority-voting model primarily for reasons of
convenience; it is the simplest political economy model with completely specified
economic and political markets (Rodrik, 1995).  Foreign aid giving can even more
easily come about in a more realistic, but also more complex, representative
democracy model with interest groups. The cost of containing free-rider problems
works to the advantage of forming smaller groups with concentrated benefits.  An
industry with relatively few voters, such as agriculture in the United States, might
easily succeed in promoting foreign aid that benefits few and hurts many.4
donor of foreign aid, even though social welfare declines as a result of the
aid payment.
4,5
It generally is the case that poor recipient countries have a higher
marginal propensity to consume certain goods, such as food or weapons,
than rich donor countries.  Hence, a transfer would raise the world prices of
these goods.  Individuals in the donor country whose factors of production
are intensively used in the production of these goods (farmers in the
agricultural sector or capital owners in the high-tech defense industry) have
incentives to vote for foreign aid, as the Stolper-Samuelson effect comes
into play.  At the same time the incomes of people with factors that are
used intensively in other sectors
will fall.  Thus, while all factor owners pay a proportional income tax to
finance foreign aid, the factor owners benefiting from the price-wage effect
are able to achieve extra gains at the cost of factor owners that are losing
from the price-wage effect.
2.  Model
6
Consider a two-country, two-commodity world in which the people of
Home decide through majority voting whether to give aid to Foreign
which, in turn, is willing to accept any amount of offered aid.  Each country
has fixed endowments with capital and labor, and each country produces
both commodities using these factors.  Industry production functions are
subject to constant returns to scale, factors are perfectly mobile between
industries, and all markets are perfectly competitive.  Within Home, the ith
person’s ownership of labor and capital, respectively, is described by:
                                                       
4 The recipient country as a whole will always benefit from aid in this model.  The
situation  where foreign aid is not accepted by the recipient country, as a result of
its own political choice, is not considered in this paper.
5 In principle, the mechanism described here can be generalized to domestic
distributional transfers.  In the case of domestic transfers, the costs of transferring
income from one group of society to another are smaller than the costs of foreign
aid, since income stays always within the country.  Differences in marginal
propensities to consume between donors and recipients, on the other hand – which
is the driving force behind price changes – tend to be larger when transfers are
international.
6 The general structure of the income distribution model is based on Mayer (1984).5
[ ] ) ( ), ( i K i L .
(1)
We explicitly assume that every person owns one unit of labor, such that
L(i) = 1, and that 0 < K(i) < K(I), where K(I) is the endowment of the
capital-richest person.
Preferences of factor-owning individuals are assumed to be
homothetic and identical within a given country, but different between
countries.  Hence, aggregate demand of a country is independent of the
distribution of income and depends on the country’s total income only, and
the two countries have different marginal propensities to consume at given
prices.  The ith person’s indirect utility function in Home is:
[ ] ) ( , ) ( i I p U i U = ,
(2)
where p is the price of good two in terms of good one and I(i) is spendable
income of individual i.  Income of individual i, in turn, is given by:
[ ][ ] t i rK w i I - + = 1 ) ( ) ( ,
(3)
where w and r are the returns on labor and capital respectively, and t is the
proportional income tax rate.  All people face the same factor returns, are
subject to the same tax rate, and own the same amount of labor; their
incomes differ from each other solely due to differences in capital
ownership.  The tax rate is set in a way to finance the chosen foreign aid
payment, T:
) ( rK wL t T + = ,
(4)16
The key behind the political explanation of foreign aid is that aid
giving affects the international terms of trade which, in turn, changes the
distribution of income among factor owners in the donor country.  The
income distribution effects of aid giving will be significant if there are
sizable differences in propensities to consume between donor and recipient
country and the domestic distribution of factor ownership is quite unequal.
It is likely that at least some people will benefit from aid giving if these
conditions prevail.  Should the beneficiaries from aid giving also be
decisive in choosing economic policies, the political choice of the donor
country will be to give foreign aid.
We formulated a political economy model of foreign aid under the
assumption that the distribution of income effects are determined in a
standard Heckscher-Ohlin model and that foreign aid policy is adopted
through majority voting in a direct democracy.  Our choice of economic
and political models was motivated by a desire to formulate a specification
of endogenous aid policy formation that is both complete and easily
tractable.  The underlying implications  from our simple model, however,
carry over to more realistic, though less tractable descriptions of the
political process as well.  In fact, political choice of foreign aid is even
more likely to come about in a representative democracy with interest
groups.
There exists a huge literature on the endogenous choice of trade
policies in the presence of interest groups, as surveyed in Hillman (1989),
Rodrik (1995), and Helpman (1995).  Groups of individuals with common
interests, such as people with the same factor ownership, try to influence
economic policies by offering financial contributions or information to
politicians or competing parties during elections or to the government
currently in power.  Given such an alternative political process, one can
show that a relatively small group of people with common interests can
easily succeed in shaping foreign aid policy that benefits the small group
and hurts the vast majority of the population.  For example, the farming
industry might succeed in promoting a foreign aid policy that substantially17
raises demand for its products, benefiting farmers but hurting everyone
else.
A small interest group might succeed in setting a donor country’s
aid policy preferences because the benefits from aid might be very
concentrated while the losses are widely dispersed (see Baldwin (1982) and
Hillman (1989) among others).  Even though the country suffers a net loss
in the aggregate, the per capita gains of the few beneficiaries might be
vastly larger than the per capita losses of the many losers.  This inequality
in magnitude of individual welfare effects can be seen in equation (11) of
our model as well.  The average decline in welfare due to aid giving is
adjusted by a change in the ith person’s income share.  When foreign aid
benefits one industry only, the large gains in income shares by few gainers
is accompanied by very small income share losses of many losers, as the
sum of all income share changes must be zero.  Given this situation, the
large number of losers might have far less of an incentive to form a foreign
aid-opposing interest group than the few aid-supporting gainers.  Interest
group formation is not without costs.  Importantly, there are the costs of
containing the free-rider problem and these costs tend to rise with the size
of the group, not just in total but also per capita.  Accordingly, the many
losers from giving foreign aid might not even form an interest group to
oppose the influence-seeking by a given industry.  The few gainers, with
higher per capita gains and lower per capita organizing costs, will form an
interest group and influence policymakers through contributions and
information conveyance.  Accordingly, an industry that represents a small
part of the entire voting public succeeds in directing a country’s foreign
policy towards giving aid.18
References
Alesina, A. and D. Dollar, 1998, Who gives foreign aid to whom and why,
NBER working paper no. 6612, Cambridge, MA.
Baldwin, R.E., 1982, The political economy of protectionism, in: J.N.
Bhagwati, ed., Import Competition and Response (University of
Chicago Press, Chicago), 263-86.
Bhagwati, J.N., R. Brecher and T. Hatta, 1983, The generalized theory of
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Boone, P., 1996, Politics and the effectiveness of foreign aid, European
Economic Review 40, 289-330.
Burnside, C. and D. Dollar, 1997, Aid, policies, and growth, Policy
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D.C.
Cassen, R. 1988, Does aid work?, Clareton Press, Oxford.
Dixit, A., 1996, The making of economic policy: a transaction-cost politics
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Helpman, E., 1995, Politics and trade policy, NBER working paper no
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Hillman, A.L., 1989, The political economy of protection, Harwood
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Kemp, M.C., 1992, The static welfare economics of foreign aid: a
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Higgins (McGill-Queens University Press, Montreal) 289-314.
Lahiri, S. and P. Raimondos-Møller, 1998, Lobbying by ethnic groups and
aid allocation, EPRU WP 99-05, University of Copenhagen.
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Review 74, 970-85.
Rodrik, D., 1995, Political economy of trade policy, in: G. Grossman and
K. Rogoff, eds., Handbook in International Economics, Vol 3,
North Holland, Amsterdam.19
  T(i)
K(i)
O         k          K(h)                     K(I)
Figure 1: Individually optimal aid as a function of capital ownership when
price of the capital-intensive good rises.20
       T(i)
  K(i)
         O  K(h)           k                        K(I)
Figure 2: Individually optimal aid as a function of capital ownership when
          price of the labor-intensive good rises.

Aid, policies, and growth, Policy Research Working Paper no. 1777, The World Bank,

Endogenous tariff formation,

Lobbying by ethnic groups and aid allocation, EPRU WP 99-05,

Political economy of trade policy,

Politics and the effectiveness of foreign aid,

Politics and trade policy, NBER working paper no 5309,

The generalized theory of transfers and welfare: bilateral transfers in a multilateral world,

The Politics of Foreign Aid.

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