Aid Dependence and the Quality of Governance: Cross-Country Empirical Tests.

• Author: Knack, Stephen
• Position: Statistical Data Included

Stephen Knack [*]

Aid dependence can potentially undermine the quality of governance and public sector institutions by weakening accountability, encouraging rent-seeking and corruption, fomenting conflict over control of aid funds, siphoning off scarce talent from the bureaucracy, and alleviating pressures to reform inefficient policies and institutions. Analyses of cross-country data in this paper provide evidence that higher aid levels erode the quality of governance, as measured by indices of bureaucratic quality, corruption, and the rule of law. These findings support the need for donors to develop less costly and less intrusive ways of disseminating state-of-the-art knowledge on public sector reform in developing countries.

1. Introduction

   Research on aid effectiveness to date has focused on the impact of aid on growth, infant mortality, and the composition of government spending (e.g., Boone 1996; Feyzioglu, Swaroop, and Zhu 1998; Burnside and Dollar 1998, 2000). This study examines a different but related issue: Does aid influence the quality of governance? Analyses of cross-country data provide evidence that higher aid levels erode the quality of governance, as measured by indices of bureaucratic quality, corruption, and the rule of law. This negative relation strengthens when instruments for aid are used to correct for potential reverse causality, and is robust to changes in the sample and to several alternative forms of estimation.

   Section 2 summarizes previous arguments in the literature on how aid can improve or impair the quality of governance. Section 3 describes the data. Empirical evidence is presented in section 4, including results of various robustness exercises. Policy implications are described in section 5, including the need for developing less intrusive and less costly strategies for technical assistance.

2. How Aid Can Influence Governance

   Good governance--in the form of institutions that establish a predictable, impartial, and consistently enforced set of rules for investors--is crucial for the sustained and rapid growth in per capita incomes of poor countries (e.g., North 1990; Knack and Keefer 1995; Keefer and Knack 1997; Clague et al. 1999). Moreover, the impact of good governance appears to be progressive, with at worst neutral effects on the distribution of incomes within countries, and some evidence of egalitarian effects on income distributions (Knack and Anderson 1999). Thus, the question of foreign aid's impact on the quality of governance is potentially of great importance for the incidence of poverty.

   Theory is ambiguous with respect to aid's impact on the quality of governance. There are several reasons to expect that aid might be associated with improved governance. Inefficient institutions and policies are often deliberately chosen by self-interested leaders with short time horizons. But in some cases low government revenues could be a binding constraint on the development of well-functioning bureaucracies and legal systems. For example, a $100,000 U.S. Agency for International Development (USAID) project resulted in a dramatic increase in the number of cases heard annually by the Costa Rican constitutional chamber, by purchasing computers for a new case tracking system and hiring court clerks (a new concept at the time in that country) to support the seven judges. Foreign aid is sometimes used for improved training and increased salaries for public employees, including police, judges, and tax collectors. As salaries increase, more competent bureaucrats can be recruited and bribe solicitation reduced (V an Rijckeghem and Weder 2001). Resulting improvements in the investment climate and higher tax collections in turn produce additional revenues, and improve the government's creditworthiness, reversing a vicious circle.

   Aid sometimes takes the form of programs intended to strengthen the legal system, public financial management, and other responsibilities of the public sector. In recent years particularly, multilateral institutions such as the World Bank and IMF, and bilateral donors such as USAID, have made governance reforms a priority. Transferring developed-nation institutions to less-developed nations via technical assistance has proven very difficult, however. Judicial reform in Haiti funded by USAID has been a particularly expensive and abject failure. Sweden's aid agency expended large resources over 15 years to build Tanzania's auditing capacity, but with no impact on public sector accountability, because the Auditor General's office still does not use auditing firms to audit government expenditures (Brautigam 2000).

   Aid could also improve the quality of governance through conditionality effects. For example, the World Bank's International Development Association lends about $6 billion per year to its poorest members on highly concessionary terms, with allocations based in large part on the Bank's assessments of the quality of policies and public sector institutions. At the margin, such conditionalities can increase the incentives of aid-recipient governments to implement public sector reforms.

   However, analysts generally conclude that conditioning aid on policy and governance reform is largely ineffective (Collier 1997; Dollar and Pritchett 1998; Stiglitz 1999; Kapur and Webb 2000), raising doubts about the ability of donors to strengthen the quality of governance in recipient nations through imposing governance-related conditions on aid. In an examination of 29 cases in which politically motivated aid sanctions were applied, Crawford (1997) concludes that political conditionality is usually ineffective. [1]

   Aid revenues could be associated with improved governance even if they are expended entirely on consumption, by facilitating the survival of reform-minded governments. Aid can be used for adjustment costs, compensating groups favored under the inefficient policy regime who lose rents when corrupt practices are curbed by reforms. As Rodrik (1996) notes, however, external resources can help bad as well as good governments survive, by reducing the cost of doing nothing as well as reducing the costs of reforming. By providing an alternative source of revenues, aid can relieve pressure on recipient governments to establish the efficient policies and institutions necessary for attracting private capital. Large-scale foreign aid was originally justified largely as a means of overcoming capital shortages, yet many aid recipients maintain policies that have the effect of restricting inflows of private capital (Bauer 1984, Ch. 3). Similarly, the end of U.S. aid -- which had been generous in the 1950s -- is often credit ed for the Korean and Taiwanese reforms of the 1960s (Rodrik 1996).

   Aid can even increase political instability, by making control of the government a more valuable prize (Grossman 1992). Maren (1997) blames Somalia's civil wars on competition for control of large-scale food aid.

   Political scientists have argued that aid weakens governmental accountability, by retarding the development of a healthy "civil society" underpinning democracy and the rule of law. The evolution of democracy and the rule of law in the West was critically related to monarchs' needs for tax revenues, particularly for fighting wars (Tilly 1985). Elites who provided monarchs with most of their tax revenues in turn demanded accountability from government. Accountability was gradually extended from the elite to the people at large (Brautigam 1992). England is the prototypical example, with the Magna Carta and the Glorious Revolution being two of the most prominent events in the process of increasing accountability of monarchs to elites, followed eventually by gradual extension of the suffrage [2] (North 1990). Foreign aid may short-circuit these processes in developing countries by reducing government's dependence on its citizenry for tax revenues [3] (Karl 1997; Moore 1998). The journalist and ex-aid worker Michae l Maren (1997) has written extensively on how large-scale aid methodically undermined Somalia's civil society in the 1980s. With high levels of aid, recipient governments are accountable primarily to foreign donors rather than to taxpayers: "those with the loudest single voice on revenue and expenditure decisions are international lending agencies" (Brautigam 1992, p. 11; see also Morss 1984). Meyer (1992) describes the failure of a series of donor-funded projects designed to build rural institutions in the Dominican Republic but which served short-term donor rather than domestic needs and undermined existing institutions. The payoff to government officials of building institutions according to donor specifications exceeded their payoff from building them according to domestic demands. When external funding ended, the new institutions broke down.

   Foreign aid can also weaken the state bureaucracies of recipient governments. This can occur most directly by siphoning away scarce talent from the civil service, as donor organizations often hire away the most skilled public officials at salaries many times greater than those offered by the recipient-nation government (Brautigam and Botchwey 1998; Dollar and Pritchett 1998; Brautigam 2000). Particularly when donors implement projects that local governments would have undertaken anyway, foreign aid can prevent local bureaucracies from building administrative capacity: "At times, donors have hindered the creation of effective public sectors because they saw end runs around local institutions as the easiest way to achieve project success" (Dollar and Pritchett 1998, p. 84). As a resident of Equatorial Guinea described his country's neglect of facility maintenance to Klitgaard (1990, p. 98): "Everything is given to them, they don't take care of anything and don't have to."

   Perhaps most importantly, foreign aid represents a potential source of rents, with adverse effects on the quality of the public sector and on the...