Aid, the incentive regime, and poverty reduction

Spurring growth in the developing world is one stated objective of foreign aid. Another, more commonly cited, objective is reducing poverty. Generally poverty reduction and growth go hand in hand, but could aid mitigate poverty without measurably affecting growth? The authors examine how foreign aid affects infant mortality -- an important social indicator that provides indirect evidence that the benefits of development are reaching people everywhere. They conclude that in developing countries with weak economic management -- evidenced by poor property rights, high levels of corruption, closed trade regimes, and macroeconomic instability -- there is no relationship between aid and the change in infant mortality. In distorted environments, development projects promoted by donors tend to fail. And aid resources are typically fungible, so the aid does not in fact finance these projects. Aid finances the whole public sector at the margin, which is why the quality of management is the key to effective assistance. A government that cannot put effective development policies in place is unlikely to oversee the effective use of foreign aid. On the other hand, there is a relationship between aid and a change in infant mortality when the recipient country has relatively good management. When management is good, additional aid worth 1 percent of Gross Domestic Product (GDP) has a powerful effect, reducing infant mortality by 0.9 percent. In other words, aid spurs growth and improvements in social indicators only in a good policy environment. These findings strengthen the case for targeting foreign aid to countries that have improved their economic policy. But after controlling for per capita income and population, there has been almost no relationship between countries'economic policies and the amount of aid they get. The relatively indiscriminate allocation of assistance is one factor undermining the potential impact of aid.