Foreign Aid and Fiscal Governance in Melanesia

World Development Vol. 35, No. 3, pp. 439–453, 2007 Ó 2006 Elsevier Ltd. All rights reserved 0305-750X/$ - see front matter www.elsevier.com/locate/worlddev

doi:10.1016/j.worlddev.2006.04.002

Foreign Aid and Fiscal Governance in Melanesia SIMON FEENY * RMIT University, Melbourne, Australia Summary. — Recent research suggests that foreign aid is effective at spurring economic growth in recipient countries but its effectiveness is likely to depend upon a number of factors. Arguably, the most important factor determining aid effectiveness is how recipient governments mediate foreign aid inflows. This paper investigates this issue for the Melanesian countries of Fiji, Papua New Guinea, the Solomon Islands, and Vanuatu for the period 1989–2002. Results suggest that foreign aid has led to increases in developmental expenditures and to falls in tax revenues and borrowing. Results also suggest a very different response to aid grants versus loans. Ó 2006 Elsevier Ltd. All rights reserved. Key words — foreign aid, public sector, Pacific, Melanesia

1. INTRODUCTION Recent research suggests that foreign aid is, on average, effective at spurring economic growth in developing countries. The research also reveals that aid effectiveness is likely to depend upon a number of factors. These factors include the macroeconomic policy environment (Burnside & Dollar, 2000), vulnerability to external shocks (Collier & Dehn, 2001; Guillaumont & Chauvet, 2001), political stability (Chauvet & Guillaumont, 2002), post-conflict periods (Collier & Hoeffler, 2002), the level of democracy (Islam, 2003; Svensson, 1999), institutional quality (Burnside & Dollar, 2004), and whether the recipient is located in the tropics (Dalgaard, Hansen, & Tarp, 2004). However, arguably the most important factor determining aid effectiveness is how recipient governments mediate the foreign aid flows they receive. Since most foreign aid is provided directly to the public sectors of developing countries, how they allocate and respond to aid inflows will largely determine the impact of aid on economic growth and poverty reduction. This issue is of increasing importance, given the commitment of member countries of the United Nations to achieve the Millennium Development Goals by 2015 and the subsequent increases in foreign aid budgets. This paper examines the issue for Melanesian recipients during the period 1989–2002. Melanesia includes Fiji, Papua New Guinea (PNG), the Solomon Islands, and 439

Vanuatu. 1 These countries are located in the Pacific and, with the exception of Fiji, are often referred to as fragile states. They are perceived to have weak public sectors that do not use aid flows effectively leading to some commentators calling for drastic reductions in the level of foreign aid provided to them. This paper employs fiscal response models to examine public sector responses to aid inflows. Fiscal response studies stem from Heller (1975) and examine the impact of foreign aid on public sector expenditures and revenues. 2 The approach is based on a theoretical framework in which public sector decision makers act to attain annual revenue and expenditure targets. * This paper is partly supported by the Australian Agency for International Development (AusAID) and by a project sponsored by the Australian Research Council (ARC) and World Vision of Australia (WVA) (LP0562486). The views expressed in this paper are those of the author and not necessarily those of the Commonwealth of Australia, the ARC or WVA. The Commonwealth of Australia accepts no responsibility for any loss, damage, or injury resulting from reliance on any of the information or views contained in this paper. The author is grateful to Mark McGillivray, Osman Ouattara, Sinclair Davidson, Tim Fry, James Gilling, Nikunj Soni, and four anonymous referees for useful comments. The author is also grateful for feedback obtained from participants of an AusAID seminar, November 2004. Final revision accepted: April 10, 2006.

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In a well-cited paper, Gang and Khan (1991) used Heller’s model to examine the impact of aid on the public sector in India. Since then, a number of important improvements have been made to the fiscal response approach. Developments include (i) drawing inferences from reduced form as well as structural equation parameters (White, 1994), (ii) the specification of more realistic budget constraints (FrancoRodriguez, McGillivray, & Morrissey, 1998), (iii) treating foreign aid as endogenous (Franco-Rodriguez et al., 1998), and (iv) disaggregating the foreign aid variable (Mavrotas, 2002). 3 However, two remaining and important criticisms relate to the underlying theoretical model and the use of estimated target variables. Specifically, the literature has been unable to incorporate asymmetric preferences into its framework without introducing theoretical inconsistencies and the use of estimated target variables casts serious doubts over the reliability of results and conclusions of existing studies (McGillivray & Morrissey, 2001). This paper accounts for these issues in applying a fiscal response model to Melanesian countries. Specifically the paper investigates the impact of foreign aid on recurrent expenditures, developmental expenditures, tax revenues, and borrowing behavior in these countries. A fiscal response model is developed which incorporates the asymmetric preferences of Melanesian public sector decision makers. Moreover, the model is based on public sector decision makers acting to achieve annual expenditure appropriations and revenue estimates as the targets used in the previous literature. Expenditure appropriations and revenue estimates are available from the recipients’ annual budget papers. Despite studies sometimes alluding to their crudely estimated target variables as budgetary appropriations and estimates, it has not been made explicit and such data have not been collected since they are not readily available to researchers. Further, following the most recent literature on aid effectiveness, foreign aid is disaggregated into aid grants and aid loans. 4 If public sector decision makers respond differently according to the nature of aid flows, then investigating the impact of total foreign aid might lead to aggregation bias. Melanesia is a region of substantial interest. Melanesian countries have typically received some of the highest levels of per capita aid in the world. Despite receiving large amounts of foreign aid and being rich in natural resources, they have failed to prosper and have performed

particularly poorly during the 1990s. They have been characterized by political instability, internal ethnic conflict, inefficient public sectors, large informal sectors, and a vulnerability to external shocks such as natural disasters. Poor governance is often cited as a major contributory factor for the poor economic and social progress experienced by Melanesian countries and the management of foreign aid and other financial flows is a crucial component of good governance. Further, there is currently very little empirical research that has examined aid effectiveness in the region. 5 The difficulties experienced by Melanesian countries have stimulated a number of responses from the international donor community, aimed largely at improving the level of public sector management. Civil and political unrest in the Solomon Islands led to the Regional Assistance Mission to the Solomon Islands (RAMSI) in 2003, in order to restore peace and security and stabilize government finances. Further, in 2004, the Enhanced Co-operation Program (ECP) led to a number of Australian public servants taking positions in various PNG government departments to help strengthen law and order and improve the level of economic and public sector fiscal management. The remainder of this paper is organized as follows. A fiscal response model is developed in Section 2. The model incorporates the asymmetric preferences held by decision makers in Melanesian countries and is based on them acting to achieve annual revenue estimates and expenditure appropriations. The data and estimation procedure are discussed in Section 3 and the results are presented and interpreted in Section 4. Finally, Section 5 concludes with some policy implications arising from the research. 2. A FISCAL RESPONSE MODEL FOR MELANESIAN PUBLIC SECTORS The task of public sector decision makers in Melanesia is to allocate revenues among expenditures subject to budgetary constraints. In doing so they strive to attain exogenous expenditure appropriations and revenue estimates. They derive utility from various expenditure and revenue categories and their utility function can be represented by U ¼ f ðR; D; T ; A; BÞ;

ð1Þ

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where R represents recurrent expenditures, D represents developmental expenditures, T represents tax and other recurrent revenue, A represents foreign aid and B represents non-aid borrowing. All variables are for period t. In the following exposition, total foreign aid is used in the model. 6 Recurrent expenditures include expenditures on wages and salaries and regular administrative and maintenance costs of running government departments and services. Developmental expenditures relate to capital expenditures but also include other expenditures on projects that are consistent with a development strategy. This level of expenditure and revenue disaggregation is appropriate given the budgetary mechanisms prevalent in Melanesian countries and the reporting in their annual budgets. Foreign aid donors are often largely responsible for the funding of a development budget although recipient governments also make a financial contribution each year. It is often asserted that donors want to support developmental expenditures (D) and do not want to observe their aid flows allocated to recurrent expenditures (R). The merits of this view are discussed in the conclusion of the paper. The type of preferences that public sector decision makers possess and the subsequent specification of the utility function has been an area of dispute. Early fiscal response studies (Gang & Khan, 1991; Heller, 1975) specify a utility function in linear-quadratic form which incorporates asymmetric preferences that policymakers in developing countries are believed to possess. This implies that overshooting and undershooting target variables results in different losses in utility. However, using their specification, Binh and McGillivray (1993) demonstrate that utility is not maximized when all targets are reached and propose a quadratic utility function with perfectly symmetric preferences. Moreover, Franco-Rodriguez et al. (1998) dispute the existence of asymmetric policy preferences, arguing that there is no reason a priori why undershooting targets is worse than overshooting them and vice versa. From conducting interviews with those responsible for implementing the annual government budget in Melanesian countries, it is clear that the public sector decision makers in these countries possess asymmetric preferences and efforts should be made to incorporate them into the underlying model. Although public sector officials work to their annual expenditure

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appropriations and revenue estimates and exactly meeting them is optimal, they do not lose as much utility overshooting them than when they undershoot them. This applies to all expenditure and revenue categories. Accountability and financial mechanisms to prevent expenditure overruns exist in all Melanesian countries but they are rarely enforced. Further, despite the political costs of exceeding revenue estimates, decision makers in these countries view overshooting these estimates as a superior outcome to undershooting them. Therefore, following Feeny (2006) an alternative utility function is posited. It captures asymmetries in the loss of utility experienced by decision makers and is also consistent with the notion that utility is maximized when they reach their targets: U ¼ a0  ½exp½a1 ðR#  RÞ  a1 ðR#  RÞ  1  ½exp½a2 ðD#  DÞ  a2 ðD#  DÞ  1  ½exp½a3 ðT #  T Þ  a3 ðT #  T Þ  1  ½exp½a5 ðA#  AÞ  a5 ðA#  AÞ  1

ð2Þ

 ½exp½a4 ðB#  BÞ  a4 ðB#  BÞ  1:

The variables with a # attached relate to target variables. In this paper, these targets refer to expenditure appropriations and revenue estimates discussed below. Utility reaches a maximum at a0, which is achieved when all expenditure appropriations and revenue estimates are met. However, this alternative specification is primarily a conceptual contribution since Feeny (2006) demonstrates that the underlying utility function makes little difference empirically. Specifically, the utility function (2) results in very similar structural equations to a quadratic function with symmetric preferences. The same set of results and conclusions would be identified, therefore, if the standard quadratic loss function is specified with perfectly symmetric preferences. The use of expenditure appropriations and revenue estimates warrants some discussion. Each year they are published in the annual budget documents of Melanesian countries. The setting of annual expenditure appropriations and revenue targets is the task of a budget unit within the department or ministry of treasury or finance. Appropriately, revenue projections are estimated first. This is done through modeling the movements of the economy and in consultation with inland-revenue officials and aid

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donors. On the expenditure side, the budget unit often consults expenditure line managers and the heads of ministries in preparing expenditure appropriations. 7 Annual expenditure appropriations and revenue estimates are formulated and published in years prior to that to which they apply. Target variables are therefore deemed exogenous to the decision makers; they are unable to influence them in the current year. 8 This paper uses the aid flows which are recorded in the recipients’ annual budget papers in the empirical analysis. Similar to the estimates for other revenue variables, an estimate of the foreign aid that recipients expect to receive is provided in their annual budgets and is used as the target variable for aid. 9 Gross aid amounts enter the budget accounts while repayments on previous aid loans are included as recurrent expenditures. The approach is appropriate since it is the decisions of Melanesian public sectors which are modeled in the paper. Previous fiscal response studies have employed donor measures of aid. Official Development Assistance (ODA) disbursements are typically used for the aid variable and ODA commitments as the target variable for aid. Commitments represent the amount of aid pledged by donors while disbursements relate to the amount of aid that is actually spent. The aid data recorded in the budgets of Melanesian recipients are compared with donor aid data reported to the Development Assistance Committee (DAC) of the OECD. Although ‘‘on-budget’’ foreign aid accounts for close to 100% in the cases of Papua New Guinea and the Solomon Islands, it accounts for around 30% in the cases of Fiji and Vanuatu during the sample period. One reason for the shortfall in Fiji and Vanuatu is the large proportion of aid in the form of technical assistance provided to these countries. The salaries of external consultants will not enter public sector accounts. However, donors also find it less onerous to carry out aid projects without reporting to the central government. This circumvents the need to use existing government systems and avoids potential conflict with recipient officials. Incorporating ‘‘off-budget’’ aid flows into the model is important if it is believed that recipient public sector officials respond to them through their expenditure and revenue raising decisions. Incorporating this possibility into the theoretical and empirical model remains

an area for future research. Including off-budget aid flows introduces problems with the recipient government’s budget constraint. As outlined below, expenditures must equal revenues. Off-budget aid flows could be treated as additional revenue but it is not possible to determine whether the constraint should be balanced by increasing recurrent or developmental expenditures. Moreover, in Melanesian countries, public sector officials are usually unaware of off-budget aid projects and it is therefore assumed that they do not incorporate them into their expenditure and revenue raising decisions. Employing revenue estimates and expenditure appropriations from budget papers is an important departure from the fiscal response literature. The target variables used in previous studies have had to be crudely approximated by obtaining the fitted value from a regression of exogenous regressors on each actual variable. This is the major criticism of the fiscal response approach. As outlined by Feeny and McGillivray (2005) there are serious problems associated with the use of estimated target variables. Two problems associated with target variables estimated in this way are identified by White (1994). Firstly, target variables independently derived in this manner will not be consistent with a public sector’s overall budget constraint. Secondly, if the functional fit from the regression used in the target generation is very good, with a R2 close to one, the target will be highly correlated with its actual variable. In estimating the structural equations, a large amount of the variation in the dependent variable will therefore be explained by the parameter on its target leaving a very small amount of residual variation to be picked up by the parameters on the other explanatory variables. Conversely, if the R2 is close to zero, it can be difficult to argue that the fitted value is a valid approximation for the target. A third problem of utilizing target variables in fiscal response studies relates to the problem of using generated regressors (see, e.g., Pagan, 1984; Wooldridge, 2002). Unless the target variables are asymptotically orthogonal to the error terms of the structural equations the resulting standard errors will be inefficient and the t-statistics invalid. Although it is possible to correct the standard errors via an adjustment, no fiscal response studies have undertaken this correction. An important and related issue to these problems is identified by

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Feeny and McGillivray (2005). Since the target variables are simply fitted values of the actual (endogenous) variables, it follows that they equal their corresponding actual variable less the residual term. Given that each structural equation contains the target corresponding to its dependent variable, estimating these equations involves a regression of each dependent variable on itself. This leads to biased and inconsistent estimates. A further criticism applies to the borrowing target. Virtually all fiscal response studies assume that planned (targeted) borrowing is equal to zero. Although this does not preclude borrowing, it is a highly dubious assumption given that developing countries often plan to borrow to cover planned expenditures. An analysis of government budget documents reveals that this is certainly the case for Melanesian countries. Successive governments have planned to borrow in the following year in order to cover expenditure appropriations. The fiscal response model developed in this paper employing revenue estimates and expenditure appropriations avoids the problems associated with using crudely estimated target variables. Following Franco-Rodriguez et al. (1998), the objective of public sector decision makers is to maximize their utility function (2) subject to the two following budget constraints: DþR¼T þAþB

ð3Þ

and R 6 q1 T þ q2 A þ q3 B;

ð4Þ

where q1, q2, and q3 represent the proportions of tax, foreign aid, and borrowing, respectively, allocated to recurrent expenditures. It follows that ð1  q1 Þ, ð1  q2 Þ and ð1  q3 Þ are the proportions of these revenues allocated to development expenditures. The rationale for the inequality (4), provided by Franco-Rodriguez et al. (1998), is that there are external constraints, from donors and domestic interest groups, which limit the allocation of revenues to recurrent expenditures. There is therefore no guarantee that expenditures can be met even if revenues are sufficient. The constraint is particular applicable to Melanesian countries. Due to the existence of clan-based support systems, Melanesian public officials are under intense pressure to support and meet the needs of their own constituents. Moreover, a large amount of aid to Melanesia is provided in the form of pro-

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jects allocated to the development budget and these projects cannot practically be fully redirected toward recurrent expenditures. 10 To investigate the impact of aid on Melanesian public sector fiscal behavior, structural and reduced form equations are derived and estimated from maximizing (2) subject to (3) and (4). These equations are provided in the Appendix of this paper. 11 3. DATA AND ESTIMATION PROCEDURE Annual data for the variables were obtained from the budget documents of the Melanesian recipients over the period 1989–2002, although data for Vanuatu are only available from 1998. 12 All data are converted to US dollars, expressed in constant (1995) prices and as a ratio to population to account for country size. Variable definitions, their average (mean) values, and data sources are provided in Table A.1 in the Appendix. Correlation coefficients between the actual variables and their targets are provided in Table A.2. Correlation coefficients for Vanuatu are sometimes low due to the smaller number of observations for the country. Overall, Table A.2 indicates that correlation coefficients fall in a range that they are not subject to the criticisms identified by White (1994), discussed above in relation to estimated target variables. This paper uses pooled data for the four Melanesian recipients under consideration. With the notable exceptions of Heller (1975) and Khan and Hoshino (1992), this approach is a departure from the literature which uses timeseries data for a single country. 13 The poor availability of historical budget documents prevented a time-series analysis for each recipient. Further, the approach is justified due to the similarities of the recipients under consideration. Table 1 provides a comparison of selected indicators. The table indicates that Melanesian countries are at a similar level of development with comparable economic and social indicators. Fiji has the highest level of GDP (PPP) per capita and Human Development Index (HDI) score. The Solomon Islands have the lowest level of GDP (PPP) per capita while PNG has the lowest HDI score. Although Papua New Guinea has a population exceeding five million, other countries have populations below one million. These countries have been large recipients of foreign

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WORLD DEVELOPMENT Table 1. Selected indicators for Melanesian countries Population 2002 GDP per capita PPP HDI Average aid to GNI Average aid to (thousands) ($US) (2002) (2003) (%) (1989–2002) total expenditure (%) (1989–2002)

Fiji Papua New Guinea Solomon Islands Vanuatu

823 5,378 443 206

5,580 2,358 1,687 2,736

0.75 0.52 0.59 0.66

2.7 8.7 16.8 19.8

3 22 35 15

Notes: Sources include the World Bank (2005), UNDP (2005), Fiji Ministry of Finance and National Planning (various), Papua New Guinea Ministry of Finance and Planning (various), Central Bank of the Solomon Islands (various a, various b) and Reserve Bank of Vanuatu (various). Average aid to Gross National Income (GNI) is calculated using Official Development Assistance (ODA). Average aid to total expenditure is calculated using foreign aid that flows through the government budgets of Melanesian countries.

aid, accounting for almost 20% of Gross National Income (GNI) in the case of Vanuatu and 35% of total public sector expenditure in the Solomon Islands. Although foreign aid as a percentage of GNI and total expenditure for Fiji appears relatively small, aid flows accounted for US$56 per capita in this country during the sample period. This is far higher than the average for developing countries. Structural equations are estimated using nonlinear three-stage least squares (3SLS). This method is appropriate since public sector expenditures and revenues are linked through the budget constraint and determined simultaneously, implying that there are correlations in the error terms across the equations. Further, there are a number of restrictions that link the nonlinear parameters (consisting of qs and bs) across the equations. Nonlinear 3SLS can account for both of these issues in estimation. The computer program utilized was TSP4.5. Estimations of the reduced form equation parameters were obtained via simulations of the estimated structural equations. 4. RESULTS AND INTERPRETATION Two versions of the fiscal response model developed in the paper are estimated. The first, Model 1, uses total aid, while Model 2, disaggregates aid into aid grants and aid loans. The estimation of the structural equations provides estimates of the constraint parameters (qs) which indicate the proportion of aid allocated to recurrent and development expenditures. Results are provided in Table 2. The bs provided in the table do not have a direct interpretation but can be used in combination with the qs to compute the direct but partial impact

of aid on expenditures and revenues. This is achieved by simply substituting the estimates of the qs and bs into the system of structural equations (5)–(9). These results are provided in Tables 3 and 4. Simulation of the structural equations yields estimates of the reduced form parameters which provide the total impact of aid accounting for the indirect impacts on the other variables in the system. These results are provided in Tables 5 and 6. Arguably these results are of more interest to policy makers. Results are discussed in turn. Estimates of the structural equation parameters for both models are provided in Table 2. Statistically very good results were obtained. Convergence was obtained quickly and no computational problems were experienced in the estimations of the models. R2’s relating to the structural equations range from 0.67 to 0.97 in Model 1 and from 0.39 to 0.97 in the case of Model 2. Most parameter estimates for both models are statistically significant at the 5% level of significance. Importantly, results are not sensitive to minor changes in specification. 14 Following Gang and Khan (1999), the Akaike Information Criterion (AIC) is used to reveal the preferred model. Although disaggregating the foreign aid variable reveals very different impacts for grants versus loans, the AIC reveals a slight preference for Model 1. 15 In Model 1, all constraint parameters (qs) are statistically significant at the five or 10% level. The results indicate that, on average, 38% of foreign aid flows provided to the Melanesian recipients have been allocated to recurrent expenditures. This implies that 62% have been used for development expenditures. This relatively high figure is not surprising given the direct donor funding of Melanesian development budgets. This finding is comparable to Franco-

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Table 2. Estimates of the structural equation parameters Parameter

Estimate

t-statistic

Model 1 q1 (Proportion of T allocated to R) q2 (Proportion of A allocated to R) q3 (Proportion of B allocated to R) b1 b2 b3 b4 b5 b6

0.94** 0.38** 0.34* 0.44** 0.89** 0.43 0.04 0.77** 0.70**

26.68 4.93 1.89 2.01 3.16 1.32 0.79 3.55 3.78

Model 2 q1 (Proportion q2 (Proportion q3 (Proportion q4 (Proportion b1 b2 b3 b4 b5 b6 b7 b8

0.81** 0.02 0.98** 0.97** 0.47** 1.07** 0.60** 1.62** 0.06 0.43** 0.34* 1.09**

31.9 0.42 47.36 15.61 3.12 7.02 2.54 2.80 0.81 5.13 1.93 5.88

of of of of

T allocated to R) Ag allocated to R) Al allocated to R) B allocated to R)

Notes: Models are estimated using nonlinear three-stage least squares (3SLS). Number of observations = 47. ** and * denote statistically significant at the five and 10% level of significance, respectively. Table 3. Estimates of direct impacts of foreign aid for Model 1 Impact A A A A

on on on on

D R T B

Mechanism

Estimate

ð1  q2 Þ  ð1  q1 Þð1  q2 Þb1  ð1  q1 Þq2 b2 q2  q1 ð1  q2 Þb1  q1 q2 b2 ½ð1  q2 Þb1 þ q2 b2  ½ð1  q2 Þb5  q2 b6 

0.59** 0.19 0.61** 0.75**

Notes: Estimated impacts are derived from the estimated parameter values provided in Table 2. ** and * denote the parameters which are jointly statistically significant at the five and 10% level of significance, respectively.

Rodriguez et al. (1998) which finds that 49% of aid flows are allocated to investment for the case of Pakistan. 16 It is recognized that one country in the sample might be an outlier. Model 1 was therefore re-estimated omitting individual Melanesian recipients. There was no considerable variation in the constraint parameters from these estimations and those reported in Table 2. This indicates that similar proportions of foreign aid have been allocated to expenditures by the public sectors of Melanesian countries and lends support to the cross-country approach. With regard to the results from estimating Model 2, the constraint parameters suggest that there are important differences between grants

and loans. While results indicate that a statistically insignificant proportion of aid grants have been used for recurrent expenditures, the value of (q3) indicates that virtually all aid loans have been used for recurrent expenditures. This has serious implications since donors prefer their loans to be used for development related expenditures to ensure they generate a return. However, despite conditionality often attached to aid loans, results indicate that they have been almost entirely allocated to recurrent expenditures. Interestingly, previous studies have usually found that a greater proportion of aid loans are allocated to investment related expenditures relative to aid grants (Heller, 1975; Khan & Hoshino, 1992; Otim, 1996).

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WORLD DEVELOPMENT Table 4. Estimates of direct impacts of foreign aid for Model 2

Impact Ag on D Ag on R Ag on T Ag on Al Ag on B Al on D Al on R Al on T Al on Ag Al on B

Mechanism

Estimate

ð1  q2 Þ  ð1  q1 Þð1  q2 Þb1  ð1  q1 Þq2 b2 q2  q1 ð1  q2 Þb1  q1 q2 b2 ½ð1  q2 Þb1 þ q2 b2  ½ð1  q2 Þb5  q2 b6  ½ð1  q2 Þb7 þ q2 b8  ð1  q3 Þ  ð1  q1 Þð1  q3 Þb1  ð1  q1 Þq3 b2 q3  q1 ð1  q3 Þb1  q1 q3 b2 ½ð1  q3 Þb1 þ q3 b2  ½ð1  q3 Þb3  q2 b4  ½ð1  q3Þb7 þ q3 b8 

0.88** 0.37** 0.48** 0.07 0.35** 0.15** 0.30** 0.85** 0.94** 0.85**

Notes: Estimated impacts are derived from the estimated parameter values provided in Table 2. ** and * denote the parameters which are jointly statistically significant at the five and 10% level of significance, respectively.

Table 5. Estimates of the selected reduced form parameters for Model 1 Parameter A# A# A# A# A#

on on on on on

D R T A B

Estimate 0.18 0.00 0.22 0.75 0.41

Notes: Parameters are estimated by simulating the system of structural equations with all statistically insignificant parameters set to zero.

Table 6. Estimates of the selected reduced form parameters for Model 2 Parameter A# g A# g A# g A# g A# g A# g A# l A# l A# l A# l A# l A# l

on on on on on on on on on on on on

D R T Ag Al B D R T Ag Al B

Estimate 0.61 0.28 0.40 0.66 0.18 0.07 0.02 0.07 0.26 0.13 0.87 0.50

Notes: Parameters are estimated by simulating the system of structural equations with all statistically insignificant parameters set to zero.

A comparison of the results between the two models reveals that a similar proportion of tax revenues are allocated to recurrent expenditures. Model 1 indicates that 94% of tax revenues were allocated to recurrent expenditures

over the sample period in comparison to 81% of tax revenues suggested by Model 2. However, the models differ in their findings regarding the proportion of borrowing that is allocated to recurrent expenditures. Model 1 suggests 34%, much lower than the 97% found by Model 2. Table 3 provides estimates of the direct impact that total foreign aid has had on the expenditures and revenues of Melanesian public sectors from the estimation of the structural equations. Following Ouattara (2004), this paper derives the joint statistical significance of the structural equation parameters using Wald tests. 17 The results reveal that $1 of foreign aid has led to a 59 cent increase in development expenditures. Further, results indicate that recurrent expenditures fall by 19 cents in response to a $1 aid inflow although this finding is not statistically significant. On the revenue side, the results suggest that foreign aid is associated with large falls in both tax and borrowing revenues. Results indicate that $1 of foreign aid is associated with a fall in tax revenues of 61 cents and a fall in borrowing of 75 cents. This latter result should be looked upon favorably since it indicates that Melanesian recipients would have higher levels of debt in the absence of aid flows. Whether donors should perceive the associated fall in tax revenues as favorable is an area of dispute and is discussed below. 18 The results from the model using disaggregated aid are presented in Table 4, and again reveal important differences between the direct impacts of aid grants and loans. Aid grants lead to large increases in developmental expenditures. On average, $1 of foreign aid is associated with a 88 cent increase in developmental expen-

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ditures while recurrent expenditures fall by 37 cents. Conversely, $1 of aid loans is associated with a small reduction in development expenditures and a 30 cent increase in recurrent expenditures. This provides a clear indication that aid grants have more favorable impacts on expenditures that aid loans. Both aid grants and aid loans are associated with falls in tax revenues and borrowing but the impact of aid loans on both revenues categories is far greater than that of grants. One dollar of aid loans is associated with 85 cent falls in both tax revenues and borrowing indicating that Melanesian recipients have viewed these revenues as substitutes. All of these findings are statistically significant. Up until this point, only the direct impact of foreign aid (and grants and loans) has been discussed. As noted above, total impacts, accounting for the indirect feedback through the system of equations is likely to be of more interest to donors. Total impacts are provided by the reduced form parameters of the models and are estimated by simulating the system of structural equations. Although this technique does not provide the statistical significance of the reduced form parameters the statistically insignificant parameters of the structural equation are set to zero before the simulations were undertaken. Table 5 provides the total impact of total aid. Results indicate that total aid has a positive impact on developmental expenditures, no impact on recurrent expenditures, and negative impacts on tax revenues and borrowing. The evidence from previous studies regarding the impact of aid on expenditures is mixed. However, a number of other studies confirm the finding that aid leads to reductions in tax revenues. Indeed, Franco-Rodriguez et al. (1998), Ouattara (2004), and McGillivray and Ouattara (2005) find that aid leads to larger reductions in tax and other recurrent revenues in the cases of Pakistan, Senegal, and Coˆte d’Ivoire than in Melanesia. Contrary to other results presented here, these studies find some evidence that aid is associated with increases in borrowing in the countries under consideration. Table 6 provides reduced form estimates for Model 2, estimated with disaggregated aid. The table reveals that aid grants have quite a large positive impact on developmental expenditures and a smaller but positive impact on recurrent expenditures. Aid loans also have positive impacts on the expenditure categories but the impact is very small. Both categories of aid lead to reductions in the level of taxation revenue and borrowing although aid grants lead to

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greater reductions. The results are largely in concordance with those reported by Feeny and McGillivray (2005) examining the impact of aid grants and loans to PNG over a longer time period. Overall, results provided in this paper indicate that foreign aid provided to Melanesian countries is associated with increases in expenditures and to falls in revenues. Results from previous fiscal response studies also indicate that expenditures often increase in response to aid. However, which categories of expenditure rise and by how much is very specific to the recipient under consideration. On the revenue side, many other studies find that foreign aid leads to a reduction in tax revenues (McGillivray & Morrissey, 2001) although often foreign aid is associated with increases in borrowing (Feeny & McGillivray, 2003). The major difference between Melanesian recipients and other developing countries appears to be relatively large falls in borrowing in response to aid flows and the poor management of aid loans. The finding that foreign aid is associated with reductions in borrowing can be perceived as a good outcome. The implication is that Melanesian countries would be experiencing even greater levels of debt in the absence of foreign aid flows. Whether aid flows leading to reductions in the tax effort is good or bad is open to some debate. The issue is discussed in detail in Gupta, Clements, Pivovarsky, and Tiongson (2003). Reducing tax rates and distortionary taxes is likely to assist the private sector in increasing output and economic growth. However, it is important that reductions in the tax burden are achieved through a reduction in tax rates, rather than through weaker tax compliance. If recipients respond to aid inflows by lowering their collection efforts this will provide poor incentives to private sector companies. Unfortunately the analysis is unable to reveal which scenario has occurred in Melanesian countries during the 1990s and remains an important area for future research. In general, aid grants are found to have a far more favorable public sector response relative to loans. However, reduced form parameters indicate that grants are associated with larger falls in tax revenues. This is a result which is confirmed by a number of other studies. Odedokun (2003) finds that a high level of grants relative to total aid is found to reduce both tax to GDP and tax to expenditure ratios in low-income countries. Gupta et al. (2003) find that grants provided to countries plagued by

448

WORLD DEVELOPMENT

high levels of corruption are fully offset by reductions in the revenue effort. Therefore, grants to do not add to the aggregate amount of resources available to the recipients. Further, Bra¨utigam (2000) argues that aid grants are less preferable to aid loans since they are free resources which substitute for domestic resources. Conversely aid loans induce recipient governments to mobilize domestic resources in order to cover future repayments. The finding that aid leads to greater expenditures and lower revenues leads some researchers to conclude that aid leads to greater dependence on foreign aid donors (Remmer, 2004). Reasons as to why aid dependence is an area for concern are provided by Gupta et al. (2003). Firstly aid inflows are typically more volatile than domestic revenues which has implications for economic growth and macroeconomic stability. Secondly, poverty reducing expenditures which are financed by aid flows will be far smaller in their absence. Thirdly, aid dependence reduces incentives for recipients to adopt good policies and maintain or improve the quality of their institutions (Azam, Devarajan, & O’Connel, 1999). However, it must also be recognized that aid donors often attach conditions to their foreign calling for reductions in taxation, in particular, to trade taxes which are important sources of revenue to small, open economies. This provides an alternative explanation as to why aid flows are associated with falls in tax revenues in Melanesian countries. 5. CONCLUSION AND POLICY IMPLICATIONS This paper investigated how foreign aid has impacted on the public sector fiscal behavior of Melanesian countries from 1989 to 2002. A model was developed which employs actual budgetary appropriations and revenue estimates. Results suggest that there is scope for Melanesian public sectors to manage aid flows more efficiently. Although results indicate that aid flows have, in general, impacted positively on expenditures, they have led to fairly large reductions in revenues obtained by Melanesian recipients possibly leading to a long-term dependence on aid. Results also indicate that aid loans have been allocated almost entirely to recurrent expenditures,

providing a clear message that donors should favor aid grants. The finding that foreign aid leads to increases in development expenditures is encouraging. Although Melanesian recipients sometimes differ in their classification of expenditure items as recurrent or developmental, this is not too important to the extent that donors are, in general, willing to fund a number of different activities as long as they are development related. The emphasis of the literature on developmental or capital expenditures might sometimes be misplaced. Donors financing items such as the wages of health and education workers is arguably no less developmental than the construction of schools and hospitals. Donors should also consider supplementing recurrent expenditures since these expenditures are required to keep investments productive. Aid projects can often lead to a need for future recurrent expenditures which are necessary for their sustainability. This is particularly true for Melanesian countries which have received large proportions of foreign aid in the form of projects. To provide recipient governments (and donors) with a better idea of the future recurrent costs associated with many aid projects, this paper recommends that donors ensure that all of their aid disbursements flow through recipient budgets. Moreover, the use of local public sector systems already in place can assist in strengthening them. The finding that recipients have lowered their tax revenues in response to aid inflows is arguably an area for concern. The finding suggests that donors should assist in strengthening revenue management in addition to their traditional focus on public expenditure management. Previous literature argues that foreign aid donors have two choices. The first is that they could require more matching funds for aid projects since this should provide an incentive for further revenue collection. However, it should be recognized that tying up funds to certain areas of the budget may prevent the most efficient allocation of resources by recipient governments. Second, donors might choose to monitor the revenue raising behavior of recipients in response to their aid flows, rewarding recipients with more aid if certain revenue thresholds are maintained (Gupta et al., 2003). However, this is a very difficult exercise given that some components of revenue are out of the control of officials. Moreover any uncer-

FOREIGN AID AND FISCAL GOVERNANCE

tainty regarding the disbursal of funds will have negative impacts on the budget planning process. Finally, the results indicate the extent that expenditures and revenues have changed in response to aid inflows. The paper is not able to provide any indication of the quality of expenditures. For example, an increase in the amount of development expenditures does not necessarily imply a greater impact on poverty reduction. In resource-constrained countries, it is just as

449

important to examine the efficiency of expenditures in addition to examining their level. This is particularly true for Melanesian countries in which some social indicators are deteriorating even though expenditures in health and education are increasing. Moreover, the analysis also provides no insights into the equity of government expenditures in terms of whether they are reaching the poorest people. This is also a pertinent issue in such fragmented countries.

NOTES 1. New Caledonia is also a Melanesian country and a large recipient of French aid. However, the country is not included in the analysis due to its special status as a French territory and to the poor availability of data relating to the country’s annual budget. 2. Fungibility studies examine the impact of aid on expenditures only. Although, fungibility is defined in a number of different ways, it is generally concerned with whether recipients use aid flows for the expenditures intended by the donor. Fungibility studies include CashelCordo and Craig (1990), Pack and Pack (1990, 1993), Khilji and Zampelli (1991, 1994), Feyzioglu, Swaroop, and Zhu (1998), Nath and Sobhee (2002), Swaroop, Jha, and Rajkumar (2000), and Pettersson (2004). Since these studies often fail to include an examination of the impact of aid on public sector revenues, they are often viewed as less comprehensive than fiscal response studies (see McGillivray & Morrissey, 2001). 3. Mosley, Hudson, and Horrell (1987), Gang and Khan (1999), Binh and McGillivray (1993), Khan and Hoshino (1992), Otim (1996), McGillivray and Ahmed (1999), Franco-Rodriguez (2000), McGillivray (2000), and McGillivray and Ouattara (2005) are others that have contributed to this literature. 4. For example, Clemens, Radelet, and Bhavnani (2004) demonstrate the importance of disaggregating aid when examining the impact of foreign aid on economic growth. 5. The sparse literature includes Gounder (2001, 2002) who finds evidence of foreign aid spurring growth in Fiji and the Solomon Islands and Feeny (2005) who finds some evidence of project aid increasing economic growth in PNG. 6. Derivations for the model with aid disaggregated into grants and loans are available from the author on

request. Following most studies since Franco-Rodriguez et al. (1998), foreign aid is viewed as endogenous and is included in the utility function. Note that although public sector decision makers can derive utility from private goods and services, fiscal response studies have traditionally specified the utility function in terms of fiscal items only. The reason is that expenditures on private goods are not choice variables of public sector decision makers. Feyzioglu et al. (1998) and Swaroop et al. (2000) include a private good in the utility functions underlying their models. However, since utility is not maximized subject to private expenditures, they are not included in the estimating equations. 7. Although line managers might be asked to submit appropriations and revenue estimates, it is the budget unit that is responsible for devising them and they can differ substantially from those values recommended. Public sector decision makers in Melanesian countries act to attain these appropriations and revenue estimates even though they might appear unrealistic to them. They want to be seen to be doing their job effectively and they work toward these targets. 8. Sometimes expenditure appropriations and revenues estimates are available in t  2 for period t. However, they are often updated in the period t  1 and these are the data employed in the analysis given that public sector decision makers use the most up-to-date information. It is recognized that the methodologies employed in projecting revenue estimates and expenditure appropriations are subject to a certain amount of error. Accurately predicting revenues flows and expenditure requirements in small and sometimes volatile economies is a very challenging task. An examination of the data reveals that the annual revenue estimates and expenditure appropriations are formulated in a way that they are consistent with each other.

450

WORLD DEVELOPMENT

9. The exception is some of the data for the Solomon Islands since the country’s annual development budgets are not available. However, data relating to the annual government contribution to the development budget are available and this was added to aid disbursement data available from the OECD (2004) to derive annual development expenditures. Annual development expenditure appropriations were calculated by adding aid commitments to the estimated government contribution each year. 10. Following recent fiscal response studies, it is assumed that this constraint is binding and that external constraints might prevent the attainment of ao since at least one expenditure appropriation cannot be met (see Franco-Rodriguez et al., 1998). If it is not binding, the government is not prevented from reaching its expenditure appropriations and revenue estimates and utility can be maximized subject to (3) only. 11. Detailed derivations are available from the author upon request. Note that due to the presence of exponential terms in (2), it is not possible to derive the structural equations (5)–(9) unless Taylor’s approximation ðex  1 þ x) is used (see Feeny, 2006 for further details). Taylor’s approximation works best for small values of x so all data are expressed as a ratio to recipient population.

14. Various alterations were applied to the data and models re-estimated. These included the omission of data obtained from the Solomon Islands post 1998 due to a period of civil unrest and the estimation of variables expressed as a ratio of GDP rather than of population. 15. Note that all parameter estimates are consistent with the underlying theoretical model. As McGillivray and Ouattara (2005) recognize, the values of the as in the utility function (2) must be positive to ensure diminishing utility if the public sector deviates from its targets. Moreover, the qs represent the proportions of tax, aid, and borrowing which are allocated to recurrent revenues. Therefore, their value must lie between 0 and 1. Since the bs consist of combinations of the as and qs, McGillivray and Ouattara note they must also be positive. Recent fiscal response studies have tended to restrict the parameters to lie within their theoretical range in the estimation process. 16. Results are not directly comparable to other fiscal response studies due to different model specifications and disaggregations of foreign aid. For example, Ouattara (2004) and McGillivray and Ouattara (2005) find that 41% and 62% of aid flows are used to service debt (the focus of these studies), in Senegal and Coˆte d’Ivoire, respectively. Franco-Rodriguez (2000) finds that an unfeasible 186% of aid flows are allocated to investment in the case of Costa Rica.

12. Prior to this year, the development budget was almost entirely administered by donors while the government of Vanuatu was primarily responsible for the recurrent budget. A lack of reasonable data relating to the contribution by the government of Vanuatu to the development budget prevented the inclusion of Vanuatu prior to 1998.

17. A criticism of much of the existing fiscal response literature is that studies have not determined whether the parameters of the structural and reduced form equations are statistically significant. Since conclusions and policy implications are based on these parameters their statistical significance is very important.

13. Previous fiscal response studies, using data for a single recipient, have failed to account for the time-series properties of their data. Although the approach of using cross-country data over a short time period does not resolve the issues raised by the time-series properties of the data, there is arguably less chance of estimating spurious relationships. It is not possible to test for the presence of unit roots due to the low power of DickeyFuller tests in small samples.

18. The focus of this paper is foreign aid. However, the estimation of the structural equations also provides insights in to the impact of other revenue categories on expenditures. For example, statistically significant results from Model 1, not reported in the tables for the sake of parsimony, indicate that borrowing and tax revenues are complements and that increases in borrowing are associated with increases in developmental expenditures.

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evidence with endogenous aid. World Development, 26, 1241–1250. Gang, I. N., & Khan, H. A. (1991). Foreign aid, taxes and public investment. Journal of Development Economics, 24, 355–369. Gang, I. N., & Khan, H. A. (1999). Foreign aid and fiscal behaviour in a bounded rationality model: different policy regimes. Empirical Economics, 24, 121–134. Gounder, R. (2001). An empirical investigation of development assistance and growth for the case of Fiji. International Journal of Social Economics, 28(3), 278–294. Gounder, R. (2002). Empirical evidence of the relationship between foreign aid and economic growth: the case of the Solomon Islands. In B. M. Arvin (Ed.), New perspectives on foreign aid and economic development. Westport: Praeger. Guillaumont, P., & Chauvet, L. (2001). Aid and performance: a reassessment. Journal of Development Studies, 37(6), 66–87. Gupta, S., Clements, B., Pivovarsky, A., & Tiongson, E. R. (2003). Foreign aid and revenue response: does the composition of aid matter? International Monetary Fund Working Paper 03/176, International Monetary Fund, Washington. Heller, P. S. (1975). A model of public fiscal behaviour in developing countries: aid, investment and taxation. American Economic Review, 65, 429– 445. Islam, M. (2003). Political regimes and the effects of foreign aid on economic growth. Journal of Developing Areas, 37, 35–53. Khan, H. A., & Hoshino, E. (1992). Impact of foreign aid on the fiscal behavior of LDC governments. World Development, 20(10), 1481–1488. Khilji, N., & Zampelli, E. (1991). The fungibility of US assistance to developing countries and the impacts on recipient expenditures: a case study of Pakistan. World Development, 19, 1095–1106. Khilji, N., & Zampelli, E. (1994). The fungibility of US military and non-military assistance and the impacts on expenditures of major aid recipients. Journal of Development Economics, 43, 345–362. Mavrotas, G. (2002). Foreign aid and fiscal response: Does aid disaggregation matter? Weltwirtschaftliches Archiv, 138, 534–559. McGillivray, M. (2000). Aid and public sector fiscal behaviour in developing countries. Review of Development Economics, 4, 156–163. McGillivray, M., & Ahmed, A. (1999). Aid, adjustment and public sector fiscal behaviour in the Philippines. Journal of the Asia Pacific Economy, 4, 381–391. McGillivray, M., & Morrissey, O. (2001). Fiscal effects of aid. World Institute for Development Economics Research Discussion Paper 61/2001, World Institute for Development Economics Research, Helsinki. McGillivray, M., & Ouattara, B. (2005). Aid, debt burden and government fiscal behaviour in Coˆte d’Ivoire. Journal of African Economies, 14(2), 247–269.

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APPENDIX Structural equations: D ¼ ð1  q1 Þb1 D# þ ð1  q1 Þb2 R# þ ð1  q1 Þ½1  ð1  q1 Þb1  q1 b2 T # þ ½ð1  q2 Þ  ð1  q1 Þð1  q2 Þb1  ð1  q1 Þq2 b2 A þ ½ð1  q3 Þ  ð1  q1 Þð1  q3 Þb1  ð1  q1 Þq3 b2 B;

ð5Þ

R ¼ q1 b1 D# þ q1 b2 R# þ q1 ½1  ð1  q1 Þb1  q1 b2 T # þ ½q2  q1 ð1  q2 Þb1  q1 q2 b2 A þ ½q3  q1 ð1  q3 Þb1  q1 q3 b2 B;

ð6Þ

T ¼ b1 D# þ b2 R# þ ½1  ð1  q1 Þb1  q1 b2 T #  ½ð1  q2 Þb1 þ q2 b2 A  ½ð1  q3 Þb1 þ q3 b2 B;

ð7Þ

A ¼ b3 D# þ b4 R#  ½ð1  q1 Þb3 þ q1 b4 T þ ½1  ð1  q2 Þb3  q2 b4 A#

ð8Þ

 ½ð1  q3 Þb3 þ q3 b4 B; B ¼ b5 D# þ b6 R#  ½ð1  q1 Þb5  q1 b6 T  ½ð1  q2 Þb5  q2 b6 A

ð9Þ

#

þ ½ð1  q3 Þb5 þ q3 b6 B ; where the bs are combinations of the as and qs available from the author on request. Reduced form equations: D ¼ p1 D# þ p2 R# þ p3 T # ð10Þ þ p4 A# þ p5 B# ; R ¼ p6 D# þ p7 R# þ p8 T # þ p9 A# þ p10 B# ; T ¼ p11 D# þ p12 R# þ p13 T # þ p14 A# þ p15 B# ; A ¼ p16 D# þ p17 R# þ p18 T # þ p19 A# þ p20 B# ; B ¼ p21 D# þ p22 R# þ p23 T #

ð11Þ ð12Þ ð13Þ

ð14Þ þ p24 A# þ p25 B# ; where the ps are combinations of the as and qs.

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Table A.1. Details of the data by country Variable

Definition

Mean value (1989–2002) Fiji Papua New Guinea Solomon Vanuatu Islands

R R# D D# T T# B B# A A# Ag A# g Al A# l

Recurrent expenditures Recurrent expenditures budget appropriation Developmental expenditures Developmental expenditures budget appropriation Tax revenues Tax revenue budget estimate Borrowing (non-aid) Borrowing budget estimate Foreign aid Foreign aid budget estimate Foreign aid grants Foreign aid grants budget estimate Foreign aid loans Foreign aid loans budget estimate

649 637 127 136 644 626 109 117 22 30 5 8 17 22

285 273 60 61 229 227 38 30 77 76 48 46 29 30

216 196 138 146 187 190 44 20 123 133 107 108 16 25

330 326 56 79 301 310 27 16 58 82 26 34 32 48

Notes: All data are expressed in real (1995) per capita US dollars. The mean value of data for Vanuatu relates to the period 1998–2002. Sources include the Fiji Ministry of Finance and National Planning (various), Papua New Guinea Ministry of Finance and Planning (various), Central Bank of the Solomon Islands, various a, various b, and Reserve Bank of Vanuatu (various).

Table A.2. Correlation coefficients between selected variables and their expenditure appropriations and revenue estimates

Fiji Papua New Guinea Solomon Islands Vanuatu

R and R#

D and D#

T and T#

B and B#

A and A#

0.87 0.48 0.68 0.91

0.81 0.87 0.50 0.15

0.68 0.47 0.74 0.46

0.90 0.58 0.30 0.26

0.86 0.76 0.56 0.69