Conference name, dates, place

2007 International Conference on Ethiopian Development Studies (4th ICEDS) A Multidisciplinary Conference on the Challenges of Peace and Development in Ethiopia & the Horn of Africa, held in Kalamazoo, Michigan (WMU), August 2-4, 2007

Document Type

Paper

Presentation Date

8-2007

Abstract

The importance of capital accumulation for economic growth and hence development was widely recognized long time ago. However, developing countries - especially Sub-Saharan African countries, are still trapped in ‘vicious circle of poverty’ and failed to finance desired level of investment from their own domestic savings. Earlier models of development argued that these countries would come out of stagnation only if they got assistance from the developed world (Rodan 1961, and Chenery and Strout 1966). The two-gap model of Chenery and Strout (1966) showed that these countries are constrained with little domestic savings and foreign exchange earnings. The model predicted that foreign aid is an optimal means to break the circle and solve the two gaps (saving and foreign exchange gaps) simultaneously. However, their results were criticized both theoretically and empirically, and there has been a growing concern that foreign aid can be a substitute for domestic saving (foreign aid displacing domestic savings instead of supplementing it). This was mainly due to its negative impact on governments’ tax collection effort resulting in reduced tax revenue and its allocation for consumption rather than investment. The purpose of this paper is to empirically investigate the impact of foreign aid inflows on governments’ revenue collection and expenditure behaviors (fiscal response) using pooled data from Sub-Saharan Africa countries. To this effect we extend the neoclassical utility maximization approach of Heller (1975) by treating foreign aid as one of the endogenous variables. The reason we do this is because public policy makers anticipate foreign aid and formulate their policy accordingly. We hypothesize that different types of aid (grants and loans) and aid from different sources (bilateral and multilateral) have different impact on the recipient governments’ revenue collection and expenditure behavior. The structural equations derived from maximization problem of policy-makers’ utility function subject to financing constraints are estimated using 3SLS estimation technique. The finding of this study shows that grants and aid from bilateral sources are pro-consumption and hence have little effect on long run growth. On the other hand, loans and aid from multilateral sources are pro-investment. This research would make contributions to the existing literature as there is no other study made regarding this issue in the context of Sub-Saharan Africa countries.

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