Foreign Aid and Domestic Taxation: Multiple Sources, One Conclusion

There are genuine concerns that foreign aid may crowd out domestic tax revenue. In the short run this would have negative consequences for the recipient government’s revenue, and over a longer period could corrode governance through breaking the social contract. In recent years, two papers have presented empirical results that suggest while aid loans are free from such concerns, aid grants do crowd out tax revenue. Previous research showed that the results from the first paper, Gupta et al. (2004), did not survive the inclusion of more recent data or a minimal lag on aid variables (a simple way of reducing concerns of endogeneity). This article deals with the second contribution, Benedek et al. (2012), and finds that the results cannot be replicated. Furthermore, they suffer from serious problems resulting from a dependent variable comprised of several incompatible data sources and definitions. A variety of econometric techniques are used, including new data, with the weight of evidence pointing to a modest but positive effect from foreign aid on domestic tax revenue. Fears over a negative effect for aid grants appear unwarranted, and are accounted for by the inappropriate use of data or endogeneity concerns.