Do Foreign Aid Transfers Distort Incentives and Hurt Growth? Theory and Evidence from 75 Aid-recipient Countries

George Economides (), Sarantis Kalyvitis () and Apostolis Philippopoulos ()

No CESifo Working Paper No. 1156, CESifo Working Paper Series from CESifo Group Munich

Abstract: In this paper, 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 small growing 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 on the part of 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 between 1975 and 1995. 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.

Keywords: foreign aid; incentives; growth (search for similar items in EconPapers)
JEL-codes: D70 D90 F35 H20 (search for similar items in EconPapers)
New Economics Papers: this item is included in nep-afr
Date: 2004
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