Beitrag vom 09.04.2012

Kiel Institute for the World Economy
Kiel Working Paper No. 1762 | March 2012

The Effect of Foreign Aid on Income Inequality: Evidence from Panel Cointegration

Dierk Herzer and Peter Nunnenkamp

http://www.ifw-members.ifw-kiel.de/publications/the-effect-of-foreign-a…

Conclusion
In this paper, we examined the nature of the effect of foreign aid on income inequality using panel cointegration techniques. Employing data for 21 countries over the period 1970-1995, we found that aid exerts an inequality increasing effect on income distribution—an effect that is robust to different estimation methods, potential structural breaks, different inequality data sets, and possible outliers. This finding adds an important dimension to the aid effectiveness literature by complementing the long-lasting and still controversial debate on the growth impact of aid. In particular, our results contradict the optimistic view that aid might be effective in alleviating poverty in recipient countries even if it had no discernible average growth effects.

It has to be stressed that our analysis captured overall effects that cannot be attributed to any particular transmission mechanism. This has important implications. Previous literature focuses almost exclusively on inequality increasing effects through rent seeking by local elites in the recipient countries and the diversion of foreign aid for personal benefit. This invites calls for donors to strengthen the conditionality of aid (e.g., Boone 1996), to focus on countries with institutions that restrict rent seeking (e.g., Hodler, 2007), to prevent leakage by better monitoring the flow of aid resources within recipient countries (e.g., Bjørnskov, 2010), and to initiate and support "country-level processes that are formal, transparent and take account of the interests of the poor” (OECD, 2006: 12).

While these recommendations may help prevent inequality increasing effects of aid, they are not sufficient once other transmission channels are taken into account. Better accountability is required on both sides, recipients as well as donors. Donors do not necessarily allocate aid in line with their rhetoric on pro-poor growth, by targeting the most needy and deserving. The temptation of aid agencies to put all the blame on rent seeking in recipient countries tends to ignore that their own incentive problems may prevent aid from reducing inequality. Public outrage in the North about corruption in the South abstracts from the selfish aid motives that may lead donors to favor rich local elites. Overcoming selfish behavior and agency problems on the part of donors is unlikely to be easier than overcoming rent seeking and leakage on the part of recipients.

Isolating the impact of specific transmission mechanisms clearly warrants further research. This could help clarify the responsibility of donors and recipient countries for the distributional effects of foreign aid. Apart from more direct tests of specific transmission mechanisms, another approach may lend itself more easily to the panel cointegration methods employed in this paper. For instance, deeper insights may be gained by differentiating aid from different types of donors, using classifications of particularly selfish and more altruistic donors available from the aid allocation literature (e.g., Berthélemy, 2006). In a similar vein, it could be analyzed whether the distributional effects vary between major forms of aid such as project-specific and general budget support.