Foreign Aid, Incentives and Efficiency: Can Foreign Aid Lead to the Efficient Level of Investment?

• DOI: http://doi.org/10.1111/rode.12278
• Published date: 01 August 2017
• Date: 01 August 2017
• Author: Alok Kumar

Foreign Aid, Incentives and Efficiency: Can Foreign

Aid Lead to the Efficient Level of Investment?

Alok Kumar*

Abstract

This paper develops a two-period model in which the recipient faces borrowing constraint and the donor

is a Stackelberg follower to address two important policy questions: (i) whether foreign aid can lead to

the efficient level of capital investment in the recipient country and (ii) how does the form (e.g.

budgetary transfers, capital transfer) and the timing of aid affect the recipient’s financial savings and

capital investment. It finds that the disincentive effect of the capital transfer on the capital investment by

the recipient is larger than the budgetary transfers. It makes financial savings more attractive relative to

the capital investment for the recipient. In the absence of capital transfer, the multi-period budgetary

transfers not only lead to the efficient level of capital investment by the recipient, but also achieve the

same allocation as under commitment. The capital transfer can lead to the efficient level of capital

investment, but in this case, it completely crowds out the recipient’s own capital investment.

1. Introduction

One of the key objectives of many donor countries and aid organizations is to

promote investment and growth in the recipient countries. The effectiveness of aid

in achieving its goals has been a major concern for donors, policy makers and

researchers. There is a voluminous literature that has examined its effects on

investment, growth, poverty reduction and development in general. This literature

finds mixed evidence with regard to its effectiveness in achieving its stated goals

(e.g. Boone, 1996; Burnside and Dollar, 2000; Hansen and Tarp, 2001; Collier and

Dollar, 2002; Easterly, 2003; Kanbur, 2004; Rajan and Subramaniam, 2008; Temple,

2010).

The weak effect of aid, in part, is attributed to the incentive problems associated

with the strategic interactions among the donors and the recipients. It has been

argued that aid by altruistic donors induces recipients to reduce their own

contribution to development efforts in order to elicit more aid from donors. Donors

face a Samaritan’s Dilemma and may not be able to deter recipients (through some

conditionality) from indulging in such strategic behavior owing to time

inconsistency and credibility problems (Buchanan, 1975; Lindbeck and Weibull,

1988; Kumar, 2015). Empirical evidence also suggests that conditionality does not

work and there is a weak relationship between aid disbursement by the donors and

the implementation of required conditions or institutional reforms by the recipients

(for a review of evidence, see Svensson, 2003; Kanbur, 2004; Temple, 2010).

1

It is increasingly being realized by policy makers that different instruments of aid

affect the incentives of the recipients in different ways and the use of appropriate

*Kumar (Corresponding author): Department of Economics, University of Victoria, Victoria, British

Columbia, Canada V8W 2Y2. E-mail: kumara@uvic.ca. This research is supported by the Social Sciences

and the Humanities Research Council (Canada). The usual disclaimer applies.

Review of Development Economics, 21(3), 678–697, 2017

DOI:10.1111/rode.12278

©2016 John Wiley & Sons Ltd

instruments can improve effectiveness of aid (World Bank, 1998; Koeberle et al.,

2005; OECD, 2007). Donors provide aid in multiple ways with the financing of

capital projects/project aid and the general budgetary support/program area aid

being the two important instruments. It has been argued that the general budgetary

support may be a superior instrument of disbursing aid compared with the capital

financing as it allows for better alignment of goals of the donor and the recipient

and a more efficient use of resources (Koeberle et al., 2005; OECD, 2007).

This paper develops a two-period, two-country model to address three important

policy questions. First, whether foreign aid can lead to efficient level of capital

investment in the recipient country? Second, whether the form of aid transfer (e.g.

budgetary transfer, direct financing of capital investment) and its timing matter for

the efficiency of the capital investment? Third, what instruments can be used to

mitigate the problems of dynamic inconsistency? There are two key aspects of the

model: (i) the donor country is altruistic and behaves as a Stackelberg follower

similar to Pedersen (1996, 2001), Svensson (2000), Torsvik (2005), Hagen (2006),

etc. and (ii) the recipient country can make both the financial and the capital

investment.

In the model, there is one donor country and one recipient country.

2

The

recipient faces borrowing constraint and is unable to borrow from the international

financial markets.

3

The donor is altruistic and cares about the welfare of the

recipient. It can provide aid to the recipient through the general budgetary transfers

in both periods and the capital transfer (direct financing of capital investment) in

the first period. The capital transfer is earmarked for capital investment. However,

it is still fungible as the recipient can adjust its own contribution to the capital

investment. The recipient possesses a production technology that is increasing and

concave in the capital investment. It faces a portfolio choice problem and can

allocate its savings between financial savings at a fixed rate of interest and the

capital investment.

In terms of timing, aid is given by the donor after observing the recipient’s

choices of capital investment and financial savings. The recipient takes into account

how her decisions affect the level and the type of aid. We then have a sequential

game with the recipient as the leader.

The main findings of this paper are as follows. First, the capital transfer distorts

the relative rate of return between financial savings and capital investment and

makes financial savings more attractive to the recipient. The result is that the

capital transfer can lead to efficient level of capital investment, but in this case, it

completely crowds out the recipient’s own capital investment.

Second, both the second period budgetary transfer and the capital transfer have

disincentive effect on the recipient’s own capital investment, but, the capital

transfer has a larger disincentive effect on the recipient’s capital investment than

the second period budgetary transfer. Despite capital transfer having larger

disincentive effect, whenever it is optimal for the donor to make second period

budgetary transfer to the recipient, it is also optimal for her to make capital

transfer.

Third, the first period budgetary transfer has a positive incentive effect on the

capital investment by the recipient. The donor can use the multi-period budgetary

transfers (or transfers in both periods) to balance out their positive and negative

incentive effects on the capital investment by the recipient. Finally, in the absence

of capital transfer, multi-period budgetary transfers not only lead to the efficient

level of capital investment by the recipient, but also achieve the same allocation

FOREIGN AID, INCENTIVES AND EFFICIENCY 679

©2016 John Wiley & Sons Ltd