The relation between aid and tax has been largely debated in the literature, given its far reaching consequences: the presence of a crowding out effect of aid on domestic revenue would seriously impair the sustainability of the development process. This paper explores this relation by adopting a case study approach, which overcomes some of the common limits of the cross country literature.
The research uses time series data for Ethiopia for 1960 – 2009, a longer time series than most country studies of this kind. The estimation is based on an error correction model that allows separating long-run equilibrium relations and short-run dynamics.
The analysis shows that both foreign grants and loans have a positive relation with tax revenue in Ethiopia. This effect seems to be robust to endogeneity and to structural breaks, although clearly establishing causality remains a challenge. The results show that aid has a beneficial effect on tax revenue, which may be due to its role in supporting fiscal reforms and improvements in tax administration.