Impact of Foreign Aid on Fiscal Behaviour: A Case Study of Pakistan (1980-2000)

Abstract

Economists have been trying to study the linkages between aid inflow and government activities in developing countries. With the passage of time, the analysis has become more sophisticated. The development of two-gap models [for example, Chenery and Bruno(1962); and Chenery and Adelman(1966), among others] was an important contribution to the literature. More recently, two-gap models have been extended into threegap models. Iqbal (1995) added a fiscal constraint to the traditional saving and foreign exchange gap. In such cases, the fiscal constraint is intended to reflect potential limitations to finance public investment that may be required to support a given level of output. Another development is the analysis of effectiveness of foreign aid on the fiscal behaviour of governments in underdeveloped countries. Empirical studies by Khilji and Zampelli(1991), Khan and Hoshino(1992), among others are important contributions to this topic. All these studies gave conflicting conclusions about the effectiveness of assistance in terms of fiscal behaviour. Generally, these studies prove that aid reduces the taxation effort and is substituted between public investment and public consumption. The purpose of this paper is to examine the impact of foreign aid on the behaviour of recipient countries like Pakistan. The response is measured in terms of their public investment and consumption as well as taxation. Both official and unofficial grants and loans from bilateral and multilateral sources are included in aid. It is postulated that the government’s expenditure and revenue efforts are affected by foreign aid through a reallocation within the categories of public expenditures and revenue raising. Various previous research studies have found evidence for considerable dissipations of aid in the form of government consumption (Please.1967:Papanek, 1973; Wejsskopf, 1972a, 1972b; and Heller, 1974). Many researchers concentrate at the macro level on the relationship between foreign aid, domestic savings and economic growth (see, for example, Griffin and Enos, 1970).Recent work by Mosley, Hudson and Horrel (1987) showed that while the conclusions regarding such putative relationships may be valid, there is nevertheless an interesting question regarding the effect of foreign assistance on intermediate policy variables such as public investment, government consumption and taxation. We pursue their lead and try to trace such a relation in a simultaneous equation model applied to an underdeveloped country, Pakistan. The results confirm the hypothesis that aid does affect consumption, investment and taxation in Pakistan. In particular, it is shown that grants and loans have different effects on investment and taxation. In the next section, we describe the model and derive the system of equations. The data, estimation procedure, and results are described in sections 3 and 4 respectively. Summary and conclusions follow.