Does foreign aid distort incentives and hurt growth? Theory and evidence from 75 aid-recipient countries

Abstract

Foreign aid transfers can distort individual incentives, and hence hurt growth, by encouraging rent seeking as opposed to productive activities. We construct a model of a growing small open economy that distinguishes two effects from foreign transfers: (i) a direct positive effect, as higher transfers allow the financing of infrastructure; (ii) an indirect negative effect, as higher transfers induce rent-seeking competition by self-interested individuals. In this framework, the growth impact of aid is examined jointly with the determination of rent-seeking behavior. We test the main predictions of the model for a cross-section of 75 aid-recipient countries. There is evidence that aid has a direct positive effect on growth, which is however significantly mitigated by the adverse indirect effects of associated rent-seeking activities. This is especially the case in recipient countries with relatively large public sectors.