Does Foreign Aid Have an Effect on Economic Growth? New Research Adds to the Debate

This piece, first published on June 15, 2016, is being republished as part of the Chicago Policy Review‘s 20th Anniversary Series. Please visit us here to learn more about the series from our Executive Editors.

There is an ongoing debate about the impact of international aid on growth, particularly in developing countries. Jeffrey Sachs and William Easterly represent the two primary strains of thought in this debate. Sachs argues that foreign aid constitutes an important instrument to reduce poverty and foster development, while Easterly suggests that foreign aid fails to reach the poor. The discussion is complicated by the task of determining “cause and effect” in the growth models. Donors might be inclined to give aid to poorly performing countries with lower growth rates, but they also might prefer giving aid to successful beneficiaries with high growth levels.

Researchers Sebastian Galiani, Stephen Knack, Lixin Colin Xu and Ben Zou contribute to this debate in a new NBER paper. They use eligibility for support from the International Development Association (IDA) as an instrument for foreign aid. The study finds evidence that aid increases economic growth among poor countries in which aid is a large source of funding. The eligibility for IDA support depends on a country’s relative poverty level, defined as gross net income (GNI) per capita being below an established threshold and updated annually for inflation. Once a country has exceeded the threshold and is considered to be creditworthy, it is no longer eligible for IDA.

The sample consists of 35 countries that crossed the IDA income threshold from below between 1987 and 2010. This sample comprises poor and financially constrained countries that receive large amounts of aid, such as India, Sudan, Bolivia, and Nigeria, among others. Using data on income, investment, growth rates, and other variables from the World Bank’s World Development Indicators and the OECD’s Development Assistance Committee, the authors control for fixed effects, or factors that stay the same within a given country during the time period of interest.

The results show that a one percent increase in the aid to gross net income (GNI) ratio increases annual real per capita GDP growth by 0.031 percentage points. Additionally, the authors find that accelerated reductions in aid as a result of crossing the threshold on average have a negative effect on growth. Indeed, reducing the aid to GNI ratio by one percentage point at the period of crossing the threshold, on average, reduces the real per capita GDP growth by approximately 0.35 percentage points. Based on these estimates, the authors argue that the significant impact of foreign aid on growth could be explained by improving economic policies and governance quality among the countries in the sample.

Even though the debate over aid, growth, and development is far from over, this research furthers our understanding of the link between these variables. Most importantly, it provides evidence of a negative impact on growth when aid reduction decreases at an accelerated pace in poor countries. When tailoring aid policies for developing countries, improving aid allocation and the quality of governance and institutions appear crucial for long-term success.

Article Source: Galiani, Sebastian, Stephen Knack, Lixin Colin Xu, and Ben Zou. “The Effect of Aid on Growth: Evidence from a Quasi-Experiment.” National Bureau of Economic Research Working Paper 22164, 2016.

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