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Do Foreign Aid Transfers Distort Incentives and Hurt Growth? Theory and Evidence from 75 Aid-recipient Countries

  • George Economides
  • Sarantis Kalyvitis
  • Apostolis Philippopoulos

In this paper, foreign aid transfers can distort individual incentives, and hence hurt growth, by encouraging rent-seeking as opposed to productive activities. We construct a model of a small growing open economy that distinguishes two effects from foreign transfers: (i) a direct positive effect, as higher transfers allow the financing of infrastructure; (ii) an indirect negative effect, as higher transfers induce rent-seeking competition on the part of self-interested individuals. In this framework, the growth impact of aid is examined jointly with the determination of rent-seeking behavior. We test the main predictions of the model for a cross-section of 75 aid-recipient countries between 1975 and 1995. There is evidence that aid has a direct positive effect on growth, which is however significantly mitigated by the adverse indirect effects of associated rent-seeking activities. This is especially the case in recipient countries with relatively large public sectors.

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Paper provided by CESifo Group Munich in its series CESifo Working Paper Series with number 1156.

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Date of creation: 2004
Date of revision:
Handle: RePEc:ces:ceswps:_1156
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  1. Tavares, Jose, 2003. "Does foreign aid corrupt?," Economics Letters, Elsevier, vol. 79(1), pages 99-106, April.
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  18. Mosley, Paul & Hudson, John & Horrell, Sara, 1987. "Aid, the Public Sector and the Market in Less Developed Countries," Economic Journal, Royal Economic Society, vol. 97(387), pages 616-41, September.
  19. repec:oup:qjecon:v:112:y:1997:i:4:p:1251-88 is not listed on IDEAS
  20. Hyun Park & Apostolis Philippopoulos & Vangelis Vassilatos, 2003. "On the Optimal Size of Public Sector under Rent-Seeking competition from State Coffers," CESifo Working Paper Series 991, CESifo Group Munich.
  21. Zak, Paul J & Knack, Stephen, 2001. "Trust and Growth," Economic Journal, Royal Economic Society, vol. 111(470), pages 295-321, April.
  22. Mauro, Paolo, 1998. "Corruption and the composition of government expenditure," Journal of Public Economics, Elsevier, vol. 69(2), pages 263-279, June.
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