The impact of foreign aid on public expenditure: The case of Kenya

Foreign aid represents an important source of finance in most countries in sub-Saharan Africa (SSA), where it supplements low savings, narrow export earnings and thin tax bases. In recent years the donor community has become more stringent about fiscal discipline and good policies, which has led to freezing of donor funds to governments that do not conform with aid conditionalities. The Kenyan government has experienced such aid cuts in the past and this paper uses a welfare utility maximization function to explore how government expenditure responds to fluctuations in aid flows. The empirical results indicate that the flow of foreign aid does influence government spending patterns. There is a positive and statistically significant relationship between the share of government expenditure in gross domestic product (GDP) and the share of net disbursement of overseas development assistance (ODA). While the study finds relatively little evidence that aid leads to tax relief, there are strong indications that the government renders aid fungible by financing recurrent expenditures. The effects of an aid freeze are strong in the short term as the Treasury embarks on stringent fiscal measures to counteract the negative effects.