Aid and the public sector in Pakistan: Evidence with endogenous aid

Abstract

Summary Aid has been the principal source of development finance for the majority of developing countries over the past few decades. This has spawned a large literature on the effectiveness of aid, which remains essentially inconclusive. The empirical literature has tended to evaluate the impact of aid by including it as a variable in a regression for the determinants of some economic performance indicator. This paper follows a different strand of the literature and examines the impact of aid on public sector fiscal behavior. Aid is in general given to the public sector, thus any effect of aid is mediated by that sector. We specifically address this behavioral feature by analyzing how aid revenue affects government fiscal behavior with respect to tax, borrowing and expenditure decisions; unlike previous contributions, aid is endogenous in our model, which has a number of important implications. We estimate an econometric model that differs from previous studies not only in this respect but also by allowing domestic borrowing, in addition to aid and tax revenue, to finance both capital and recurrent expenditure. Structural and reduced form equations are derived and estimated using 1956–95 time-series data for Pakistan. Results indicate, contrary to much of the literature, that only half of aid has gone to government consumption, that it has had a slightly positive impact on public investment and negative impact on tax effort.