Foreign aid and government expansion: Evidence from low and middle income countries

Abstract

Foreign aid is an important source of revenue for most developing countries of the world, this is because it helps in public sector planning and implementation of projects. Another major argument in favor of foreign aid is that helps to bridge the gap created by the savings and investment relation. Similarly, it enhance the pace and nature of economic growth. It is further argued that foreign aid serves as take-off plans towards sustainable growth by developing countries, hitherto constrained by resource. However, as good as foreign aid is, it can also lead to the aid fungibility and this remains a gap to be filled in the literature for developing and emerging economies. The study used panel data technique for a sample of 65 low and middle income countries. Annual data sourced from the World Development Indicators were used and the variables are the ratio of government expenditure to the GDP, aid as a percentage of GNI, aid as a percentage of government expenditure, aid as a percentage of imports, the log of population, dependency ratio measured as a percentage of the population that is 65 years and above, trade openness as a percentage of GDP, per capita GDP measured in constant U.S. dollars, government revenue expressed as a percentage of the GDP, and the ratio of debt service to exports. The research covers the period of forty two years, from 1970 to 2012 which spans major economic cycles for in the lives of the countries, since attaining political independence in the 1960s. Using a fixed effect panel estimation technique that accounts for heteroskedasticity, results show aid as a percentage of Gross National Income (GNI), aid as a percentage of government expenditure, and aid as a percentage of imports have a statistically significant relationship with government spending. In addition, changes in trade openness as a percentage of GDP and changes in population are all positive and statistically significant, while per capita GNP, dependency ratio and debt service to imports all have no significant relationship Policy implications: Government should try to make judiciously use foreign aid and have institutions that will avoid aid fungibility. Government should try to diversify her economy towards import substitution and export promotion strategies.