Response of Fiscal Policy to Foreign Aid: Estimation of Impulse Response Functions by Local Projections

Baqir Fateh, University of Arkansas, Fayetteville


Does foreign foreign aid make the recipient governments spendthrift or fiscally prudent or neither? In other words, does aid resources discourage domestic revenue mobilization and stimulate government recurrent expenditure rather than funneling the resources in to long-term development projects? Empirical studies on fiscal response behavior of aid receiving governments have not offered a categorical answer yet. Results of previous studies mainly fall into the three categories - "yes", "no" and "neither". By revisiting this topic, the main contribution of current study could be the application of a newly developed time series technique - estimation of Impulse Response Functions by Local Projections - for the first time in the aid effectiveness literature. The findings presented in the form of impulse responses of fiscal policy variables to shocks to foreign aid, suggest that foreign aid depresses tax efforts, while has no significant impact on government recurrent expenditure. These results are stable to variations across the sampling composition, altering time period and data from alternate sources. Moreover, there is an indication of significant and positive association between foreign aid and public investment in the small sample of countries, however the responses do not remain significant in the larger sample with shorter time span.