On 9 June 2016 the IMF published on its website a paper entitled “What does aid do to fiscal policy? New evidence”.

As foreign aid is an important source of funding for some developing countries it is important to look at how aid is allocated and at the effect on fiscal policy. The study looked at the increases and decreases in aid dependency in 59 developing countries in the period from 1960 to 2010 and looked at the fiscal effects of aid. The study found that movements in aid dependency are frequent and have significant fiscal effects.

As well as the traditional evidence of tax displacement and aid illusion the study indicates that movements in aid dependency have asymmetric effects on fiscal accounts. Large inflows of aid undermine tax capacity and public investment while large reductions in aid result in tax and expenditure ratios being generally unchanged. The tax displacement effect tends to be temporary while the effects on expenditure are longer lasting. The adverse fiscal effects are greater in countries with low governance scores and low absorptive capacity and in those with IMF-supported programs.

Conclusion

The study concludes that large aid inflows undermine governments’ tax efforts and create a crowding-out effect on capital expenditure. Sustained financing from external sources serves to fuel current expenditure and create the aid illusion effect. Downward movements in aid have a negative effect on current expenditure because the aid spent on current expenditure items is just withdrawn as aid levels decrease. The tax displacement effect lasts around two years while the impact on expenditure items tends to continue for at least five years.

The study therefore concludes that aid inflows should be managed cautiously particularly in countries with low governance or absorptive capacity. Capacity building should be focused on maintaining or strengthening tax capacities or public investment implementation in the recipient countries. When the aid inflows to a country are reduced then efforts should focus on maintaining current spending in the recipient country as this is essential for inclusive growth.