Fiscal response in the presence of aid heterogeneity under political regime change: new evidence from Pakistan

This paper explores the effects of temporary and permanent components of foreign aid grants and loans on fiscal decisions amid changes in Pakistan's political regime over the period 1973-2020. The results show that political regimes change leads to higher government current expenditures driven by political polarization, resulting in increased foreign loans. In contrast, foreign grants are mainly influenced by donor interests and intentions in aid recipient countries, but political regimes change are irrelevant. The response of fiscal variables to political regimes change reflect conditionalities linked to foreign aid inflows, particularly via the IMF, such as increased revenue and debt service to reduce average debt maturity, thereby reducing domestic borrowing. However, current expenditures increase, thereby reducing capital expenditures due to political polarization for foreign loans and, vice versa, for foreign grants. Moreover, it affects only temporary aid components as temporary loans do not significantly affect fiscal decisions; conversely, temporary grants support revenue-based fiscal adjustments by osting revenue and domestic borrowing to cover increased debt service payments and current expenditures, thereby reducing public investment. Permanent loans promote investment and domestic borrowing but reduce current spending, without affecting tax revenues and debt service payments. Permanent grants, on the other hand, increase government borrowing, revenue, and overall government size. The findings suggest that aid donors should focus on grants rather than loans for heavily indebted countries and implement debt relief initiatives to prevent aid from being used solely for debt service repayment. Conditional aid should be provided to strengthen political institutions in order to reduce government size through expenditure-based fiscal adjustments. Additionally, temporary aid grants should be used for revenue-led fiscal adjustments, and permanent aid should target investment in countries with low GDP growth.