Foreign aid and government fiscal behaviour in low-income South Asian countries

The major purpose of this study was to analyse the relationship between foreign aid and government fiscal behaviour using a pooled sample of three low-income South Asian countries: Pakistan, India and Sri Lanka. A simultaneous equation system was developed and estimated using nonlinear three-stage least squares procedure. The results confirm the hypothesis that foreign aid affects both the expenditure and the revenue side of the recipient government budgets. Both grants and loans are used for consumption as well as for investment purposes. However, grants leak into consumption more than loans. Thus, if the purpose of aid is to generate investment, it is more helpful if donors extend loans to the developing countries than by giving grants. The results also indicate that both grants and loans increase the taxation effort. Multilateral aid actually pulls resources out of consumption and places them into investment projects. Thus the results confirm the assertion that a shift from bilateral to multilateral aid will induce a greater increase in investment. This could stem from better economic performance resulting from high-conditionality lending associated with aid from the major multilateral agencies.