Closing the Gap: A LIC’s Policy Options Under an Aid Shock

This paper uses a structural model calibrated to an aid-dependent economy to analytically explore the macroeconomic and distributional effects of a permanent aid cut under three alternative policy responses: non-concessional borrowing, domestic revenue mobilization, and uncompensated spending cuts. We find that a borrowing-only response leads to unsustainable debt and highly regressive outcomes. An uncompensated cut results in economic stagnation, higher poverty, and adverse inequality. Within the model, a strategy combining moderate borrowing with ambitious domestic revenue mobilization, while painful in the medium term, produces the most favorable path to fiscal sustainability and moderates the rise in poverty and inequality. These findings are analytical and model-based; they illustrate the trade-offs inherent in fiscal adjustment under aid dependence rather than prescribing specific policy actions.