Structural shifts in aid dependency and fiscal policy in developing countries

Foreign aid is a sizable source of government financing for several developing countries and its allocation matters for the conduct of fiscal policy. This article revisits the fiscal effects of shifts in aid dependency in 59 developing countries from 1960 to 2010. It identifies structural shifts in aid dependency and uses treatment effect methods to assess the fiscal effects of aid. It finds that shifts in aid dependency are frequent and have significant fiscal effects in developing countries. In addition to the traditional evidences of tax and investment displacement and ‘aid illusion,' we show that upward shifts and downward shifts in aid dependency have asymmetric effects on fiscal accounts in developing countries. Large aid inflows undermine tax capacity and public investment while large reductions in aid inflows tend to keep recipients' fiscal behaviour intact. Moreover, the tax displacement effect tends to be temporary while the impacts on expenditure items tend to last. Finally, we find that the undesirable fiscal effects of aid are more pronounced in countries with low governance score and low absorptive capacity.