The Substitution Trap: Development Aid and the Composition of Government Spending in Indian States

The question of whether aid supplements or substitutes government spending has long been debated in public finance literature. Building on Vadlamannati and Iacono (2026), who examine how development aid affects discretionary fiscal transfers to Indian states, we address a distinct fiscal question: how does aid exposure affect the composition of subnational government expenditure? Using panel data for 30 Indian states over 1979-2019 (41 years) and an instrumental variable strategy addressing potential endogeneity, we find that greater exposure to aid is associated with a lower share of capital expenditure and a higher share of revenue expenditure. This pattern is consistent with substitution of externally aided projects for domestically financed spending. The effect however varies systematically with electoral incentives. In states with greater electoral competition, aid is more strongly associated with capital expenditure, suggesting that electoral incentives can encourage state governments to channel external resources towards visible capital investments. Our findings extend the evidence on fiscal consequences of aid in India from the allocation of intergovernmental discretionary transfers to the composition of state government expenditure. Our findings reveal that the developmental effects of aid depend not only on how resources reach subnational governments but also on how governments subsequently allocate them.