Journal of Policy Modeling
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Does Foreign Aid Cause the Adoption of Harmful Economic Policies?

Economics Department
Fordham University
Bronx, New York 10458
(718) 817-4048

I am grateful for helpful suggestions from panel participants at the March 1997 meeting of the International Studies Association at the University of Toronto. Special thanks to my graduate assistants, Renato Reside and Glenn Pascrell, for their willingness to carry out the more tedious portions of the research reported in this paper. All errors, however, are the author's responsibility alone.

I    Introduction

The ending of the Cold War has undermined the strategic importance of foreign assistance for the United States government. Combined with American budget constraints, the prospects for ample and continued US foreign aid has diminished greatly. To further justify aid reduction some, such as Bauer (1993) and Zimmerman (1993), have argued, inter alia, that foreign assistance has caused recipient countries to adopt harmful economic policies that have caused long term economic stagnation and the perpetuation of poverty. If true, these arguments undermine the moral and humanitarian reasons that have traditionally been used to build public support for foreign aid.

Most arguments on both sides of this debate, such as Bauer (1993) against aid and Cassen (1994) for aid, have relied only on anecdotal evidence and are therefore suspect. There are several rigorous empirical studies that examine the link between aid and a country's economic policy, the most important being Gang and Khan (1990) and Khan and Hoshino (1992) and the many responses and counter responses to the two original articles. But these articles did not examine the key question raised by Bauer, does foreign aid induce the adoption of distortionary economic policies. To date I know of no rigorous theoretical or empirical study that attempts to determine whether or not there is any relationship between foreign aid and a recipient government's choice of distortionary economic policy.

To examine this question, this paper presents a standard and simple neoclassical model drawn from the public choice school that admits the possibility of foreign aid inducing a government to choose long run harmful economic policies. The paper then tests this theory on time series and cross series data to determine if what is a theoretical possibility turns out to be an empirical reality. While we find evidence supporting the contention that aid can induce harmful economic policies in one country, our general conclusion is that this is an isolated ease. In general, we find very little statistical evidence that suggest any significant link between foreign aid and a country's choice of distortionary economic policies. While there is certainly more room for additional research, at this stage we must conclude that foreign aid is not a key determining factor in a country's choice of policies. If true, then foreign aid is not a corrupting influence and the humanitarian justification for aid to countries that seek to better their people's condition continues to hold.

II    Model

Before beginning our empirical investigation, we will first attempt to understand from a theoretical perspective why a rational government might choose harmful economic policies as a result of receiving foreign aid. In developing this model I relied on the conceptual framework of the public choice school (Schwalbenberg, 1994).

Consider a government that seeks to maximize its domestic political support (S):

S = S(X,E) (1)

Such support is dependent on government expenditures (X) available to provide public goods, buy votes, or fund other activities that would generate public support for the regime. Domestic political support (S) is also dependent on the welfare of elite groups within this society (E) who might be the business elite or the military elite. The domestic support function is assumed to be positive and concave in both of its arguments.

Government expenditures (X) comes from two sources: foreign aid (A) and government domestic revenue (R). Government Revenue in turn is dependent on the tax rate (t). (A negative tax rate is a subsidy.) For simplification we assume no borrowing or lending thus yielding the following government budget constraint:

X = A + R(t), (2)

where R(0) = 0; R(t<0) < 0; Rt > 0; and Rtt < 0. The level of foreign aid (A) is determined exogenously by the donor country.

Finally, the welfare of the elite group (E) is also affected by the tax rate (t). With the introduction of an elite group we are implicitly assuming a bifurcation of this society between the haves and the have-nots. If private activities are taxed (t > 0), then the elite group will have to bear most of its burden. And if private activities are subsidized (t < 0), then the elite group will receive most of the benefit. Formally we have:

E = E(t); (3)

where Et < 0 and Ett >0.

Substituting equations (2) and (3) into equation (1) and setting the derivative with respect to t equal to zero yields the following first order condition:

SxRt + SEEt = 0. (4)

The second order condition is satisfied when.

SXX(Rt)2 + 2 SXERtEt + SXRtt + SEE (Et)2 + SEEtt< 0. (5)

Use of the implicit function theorem yields:

dt/dA = -[SXX Rt + SEXEt]/[SXX (Rt)2 + 2 SXE Rt Et + SX Rtt + SEE (Et)2 + SE Ett] < 0 (6)

In this simple model we have shown that an increase in foreign aid (A) leads to a reduction in taxation (t). In can also be shown than an increase in foreign aid (A) leads to an increase in domestic support for the regime (S). These results should be intuitively appealing. Foreign aid allows a country to increase its domestic support by reducing taxes (or increasing subsidies) on its elite and at the same time having more funds available for popular projects. The connection between foreign aid and harmful or distortionary economic policies, however, is not so straightforward.

There is for every country some socially optimal level of taxation and funding of public goods. One can easily imagine a very poor country where it would be politically difficult to tax sufficiently to finance the needed level of public goods. In such a situation foreign aid would allow taxes, which are always distortionary to some extent, to be reduced and at the same time improve the provision of needed public goods. Aid would reduced distortions in this economy.

On the other hand, it is also not difficult to imagine the possibility where financial aid is so substantial, perhaps due to the strategic importance of the country, that the government in its quest for political support is in a position where it can subsidize the private activities of its elite to the extent that they are no longer economically efficient and/or the government could spend its resources on large public projects to the point that the marginal costs borne by the aid donor outweigh the marginal benefits borne by the aid recipient. In this situation aid would increase distortions in the economy.

Theory therefore admits the possibility that a country's political leadership, driven primarily by political goals, could be induced by sufficiently ample foreign aid to choose economically harmful policies. The key question now is whether there is any empirical evidence to support this theoretical possibility.

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