, Volume 134, Issue 3-4, pp 463-488
Date: 01 Nov 2007

Does foreign aid distort incentives and hurt growth? Theory and evidence from 75 aid-recipient countries

Rent the article at a discount

Rent now

* Final gross prices may vary according to local VAT.

Get Access

Abstract

Foreign aid transfers can distort individual incentives, and hence hurt growth, by encouraging rent seeking as opposed to productive activities. We construct a model of a growing small open economy that distinguishes two effects from foreign transfers: (i) a direct positive effect, as higher transfers allow the financing of infrastructure; (ii) an indirect negative effect, as higher transfers induce rent-seeking competition by self-interested individuals. In this framework, the growth impact of aid is examined jointly with the determination of rent-seeking behavior. We test the main predictions of the model for a cross-section of 75 aid-recipient countries. There is evidence that aid has a direct positive effect on growth, which is however significantly mitigated by the adverse indirect effects of associated rent-seeking activities. This is especially the case in recipient countries with relatively large public sectors.