Roads out of poverty? Assessing the links between aid, public investment, growth, and poverty reduction

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Abstract

This paper presents a dynamic macroeconomic model that captures key linkages between foreign aid, public investment, growth, and poverty. Public capital is disaggregated into education, core infrastructure, and health. Dutch disease effects associated with aid are accounted for by endogenizing changes in the relative price of domestic goods. The impact of shocks on poverty is assessed through partial elasticities and household survey data. The model is calibrated for Ethiopia and changes in the level of nonfood aid are simulated. The amount by which (nonfood) aid should increase to reach the poverty targets of the Millennium Development Goals is also calculated, under alternative assumptions about the degree of efficiency of public investment.

Introduction

The macroeconomic effects of foreign aid and public investment have been the subject of renewed attention in recent years. Studies have focused, in particular, on the impact of external assistance on domestic savings, the government budget and fiscal policy, the real exchange rate, private investment, growth and poverty, and incentives for reform in the recipient country. Fiscal response models for instance have been used to examine the impact of aid on incentives to collect taxes and keep public expenditure under control (see for instance Franco-Rodriguez, 2000, McGillivray, 2000, McGillivray and Ouattara, 2003). Some of these studies showed that an increase in aid may lead to a decline in public savings through lower tax revenues, as governments reduce their tax collection effort.1 Others found that shortfalls in aid-depending on its composition-tend on the contrary to translate into shortfalls in domestic revenue (Gupta et al., 2003), despite the fact that aid appears to be more volatile than domestic revenues (Bulir and Hamann, 2006).

Another line of research has examined the Dutch disease effects of foreign assistance. The argument, essentially, is that if aid is at least partially spent on nontraded goods, it may put upward pressure on domestic prices and lead to a real exchange rate appreciation. In turn, a real appreciation may induce a reallocation of labor toward the nontraded goods sector, thereby raising real wages in terms of the price of tradables. The resulting deterioration in competitiveness may lead to a decline in export performance and an adverse effect on growth.2 It has also been argued, however, that if there is learning by doing (that is, endogenous productivity gains) and learning spillovers between production sectors, or if aid raises public investment in infrastructure, then the longer-run effect on the real exchange rate may be ambiguous (see Torvik, 2001, Adam and Bevan, 2003). Once dynamic considerations are taken into account, therefore, the Dutch “disease” does not have to be a terminal illness; longer-run, supply-side effects may outweigh over time adverse demand-side effects on relative prices.3

Yet another area of investigation has been the empirical link (based on reduced-form regressions) between aid and growth. In a contribution that has led to much subsequent controversy, Burnside and Dollar (2000) found that aid has no impact on the rate of economic growth in countries with poor macroeconomic policies. In an update of their initial study (Burnside and Dollar, 2004) they argued that the positive effect of aid on growth is conditional on having “good” institutions. However, a number of studies have questioned the robustness of the dependence of the aid-growth link on the policy regime.4 More generally, Doucouliagos and Paldam (2005), using meta-analysis of a large set of regression results, found that the impact of aid on growth has often been statistically insignificant, and when positive and significant, relatively small.

In parallel, to the literature on the macroeconomic effects of aid, much research has focused on the role of public investment in the growth process. “Conventional” effects have emphasized the productivity, complementarity, and crowding-out effects of public investment (see Agénor, 2004b, Chapter 12). By contrast, more recent research has focused on the degree of efficiency (or lack thereof) of public capital and the existence and magnitude of congestion costs, which imply that the productivity gains associated with a greater stock of public capital may diminish over time because of excessive use.

Few studies, however, have attempted to consider jointly the links between foreign aid, public investment, and growth. Two exceptions are Chatterjee, Sakoulis and Turnovsky (2003) and Chatterjee and Turnovsky (2005) who analyzed the impact of aid tied to public investment in infrastructure on private capital formation and growth in an open economy. However, they did not examine the composition of aid and its links with public investment, or Dutch disease effects, which may alter the long-run impact of aid and public investment on growth.5 Moreover, the models developed in these papers are parsimonious tools designed to address specific analytical issues, rather than guide practical policy decisions.

This paper fills an important gap in the literature by developing a medium-scale, quantitative macroeconomic model that captures the links between foreign aid, the level and composition of public capital, growth, and poverty. Because the model is “structural” in nature, it allows one to decompose the various channels through which aid may affect growth. This is important for two reasons. First, as noted earlier, reduced-form regressions of the aid-growth link are largely inconclusive. A structural approach may help to explain the great variety of empirical results by relating them to specific behavioral assumptions and parameters—which are likely to vary across countries. For instance, in some countries aid inflows may have a large effect on the flow of public investment, but not on the stock of public capital, because of poor management. Cross-country regressions blur these differences—to such an extent that the “average” estimates can become meaningless. Second, from a policy perspective, it is crucial to identify the mechanisms through which various factors (including policy instruments) can alter the impact of aid on growth. For instance, reserve accumulation and/or exchange rate flexibility may help to limit the impact of aid inflows on the real exchange rate. Reduced-form regressions are not well-suited to capture these indirect effects. Similarly, simply linking infrastructure and growth through constant coefficients is not sufficient from a policy perspective; infrastructure may have potentially adverse effects on growth through crowding-out effects, or by raising the budget deficit (through its impact on maintenance spending). Moreover, infrastructure may be subject to (nonlinear) congestion effects, which may become “binding” once a certain threshold is reached. Partial equilibrium approaches cannot account for these effects.

The remainder of the paper is organized as follows. Section 2 describes the model. Section 3 presents parameter estimates and the calibration procedure for Ethiopia, and discusses trend-based projections for the period 2007–15. It also presents simulation results associated with an increase in nonfood aid. These results are then used to calculate nonfood aid levels consistent with achievement of a poverty target. Section 4 performs some sensitivity analysis. The last section offers some concluding remarks.

Section snippets

The model

The model presented in this paper focuses on the fiscal and supply-side effects of aid, as well as the stock and flow effects of public investment, while accounting at the same time for congestion costs associated with the excessive use of public services. It is designed to examine how increased aid and aid-funded levels of public investment, possibly coupled with changes in the composition of these outlays, can stimulate growth and lead to sustained poverty reduction. At the heart of the model

An application to Ethiopia

The model can be used to perform a variety of policy simulations that are of crucial importance for many low-income countries involved in building growth and poverty reduction strategies supported by increased foreign assistance or debt relief. For instance, by how much would private investment and growth per capita increase if the overall level of public investment rises by a given percentage of GDP, and if at the same time the share of spending allocated to core infrastructure increases? Or,

Sensitivity analysis

The results outlined in the previous subsection are, of course, highly dependent on some of the parameters that we used to calibrate the model, as well as some of the equations that we specified. We now examine briefly how they would be altered by considering changes in the structure of the model and alternative values for some key parameters.

First, we have taken the markup rate in the domestic pricing-setting Eq. (42) to be constant. Alternatively, it could be assumed that the markup rate is

Conclusions

The purpose of this paper was to develop a macroeconomic model that captures the links between foreign aid, the level and composition of public capital, growth, and poverty reduction in low-income countries, and illustrate its functioning with a concrete application. The first part described the model and the second presented an application to Ethiopia.

As noted earlier, the fiscal parameters, namely the impact of aid on the tax rate, current government spending, and public investment, are

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    We are grateful to Ishac Diwan, Patrick Guillaumont, Michael Grimm, Henning Jensen, Jeni Klugman, Brian Ngo, Emmanuel Pinto Moreira, Mathew Verghis, an anonymous referee, the Editor of this journal, and participants at seminars at the World Bank, the University of Manchester, and the Economic Development Research Institute in Addis Ababa, for comments and suggestions. A more detailed version of this paper is available upon request.

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