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Reply to White, ‘foreign aid, taxes and public investment: A further comment’
JOURNAL OF Journal of Development Economics Vol. 45 (1994) 165-167
ELSEVIER
Development ECONOMICS
Reply to White, ‘Foreign aid, taxes and public investment: A further comment’ Ira N. Gang a,*, Haider Ali Khan b aEconomics Department-NJH, Rutgers University, New Brunswick, NJ 08903-5055, USA b Graduate School of International Studies, University of Denoer, Denuer, CO 80210, USA Received May 1993
Our paper presented and estimated a rather straightforward model of policymaker behavior in examining how developing countries allocate the foreign aid they receive. In part, our contribution was methodological, refocussing the issue of aid impacts on intermediate short-run variables and shifting the study of aid impacts from cross-country to the analysis of behavior in a single country. The paper has many obvious shortcomings: the over-restrictive formulation of the policy-maker preference function and the constraints placed on their behavior, the difficulty in empirically measuring the theoretical variables including the formulation of the targets by policy-makers, the assumed exogeneity of aid, and interpreting time series estimates in light of the short-run nature of the theoretical model. Our compromises, we felt, were reasonable and we explicitly laid out all the steps we followed in hopes that others, if they found this approach interesting, would improve on our methodology. The comment by White illustrates some of these short-comings but does little to improve on our analysis. Here we highlight some of the major issues he raises. White repeats the valid theoretical criticism by Binh and McGillivray (1993) of the loss function we employed, though as we point our in our reply (Gang and Khan, 1993) their alternative loss function empirically works out to not including a constant term in our estimating equations. We also point out that the way forward is not through the problematic quadratic loss function but through the use of an asymmetric loss function, or more flexible functional forms,
* Corresponding
author.
0304-3878/94/$07.00 0 1994 Elsevier Science B.V. All rights reserved SSDI 0304.3878(94)00033-9
166
I.N. Gang, HA Khan/Journal
ofDecelopmenr Economics 45 (1994) 165-167
White argues that our specification of the budget constraint over-restricts recipient budgetary behavior - one would like the allocation of aid among budgetary categories to be the outcome of a utility maximizing problem. We obviously agree with him. Fungibility in this context relates to ex ante budgetary decisions of the recipient country. If the recipient plans to spend a certain amount of its own resources for a specific project, and thereafter receives foreign assistance tied to that project, such aid is fungible: the earlier earmarked funds can be allocated elsewhere. However, if the recipient conducts its budgetary exercise on the premise that certain programs will be funded by project aid, and if such aid actually materializes, the budget constraint remains unaltered. In this instance the project aid is not effectively fungible. Incorporating this behavior into a utility maximizing framework makes specification and estimation extremely difficult. Our specification is not without its problems, but at least it begins to capture some of the characteristics of policy-maker behavior. Use of a single budget constraint a priori assumes that aid is 100% fungible. White criticizes our implementation of the target variables on 3 grounds: it is ad hoc - a better approach is to model the targets as outcomes of a decision-making process; if our R2 is too high it indicates our targets are too closely related to our actual expenditures/ revenues; if our R2 is too low we cannot interpret the estimated coefficients as values of the targets. Again, we essentially agree with his criticism, and ask for an alternative specification and implementation. Our formulation was clearly a compromise, which, in fact, did not suffer the problem of having too high or too low an R2. White asserts we provide a misleading interpretation of the results by not reporting reduced form coefficients. Since our interest was in the recipient’s behavior, structural equation estimates were appropriate. To the extent that our language led the reader to infer anything else, we apologize. If one is interested in forecasting the impact of a change in aid on the particular variables in the system a reduced form estimation, such as a VAR, should be pursued. The dynamic aspects of the problem could then be fully incorporated. In White’s simulation reported in his Table 3, which involves converting our structural estimates to reduced form estimates by effectively inverting the relationship in our model (through iteration), he is able to obtain point estimates of the impact. However, from this procedure one cannot infer their significance. Finally, White argues “It therefore appears that Gang and Khan’s results are derived from the way in which the target series are estimated:. . . ” To this we happily admit, and even would go a step further and say that our results are derived from our specification of the policy-maker’s preference function and our formulation of the constraints, as well. Our work, and others, reveal that the results on fungibility turn out to be very sensitive to all aspects of the specification of the problem. Rather than telling us nothing about foreign aid, taxes and public investment, at the very minimum they demonstrate the possibility for systematic exploration of these issues. They also raise questions about the budgetary alloca-
IN Gang, HA
Khan/Journal
of Decelopment Economics 45 (1994) 165-l 67
tions. Whether the specific results can be relied on for policy purposes, matter.
167
is another
References Binh, Tran-Nam and Mark McGillivray, 1993, Foreign aid, taxes and public investment: A Comment, Journal of Development Economics 41, no. 1, 173-176. Gang, Ira N. and Haider Ali Khan, 1993, Reply to Tran-Nam Binh and Mark McGillivray: ‘Foreign Aid, Taxes and Public Investment: A Comment’, Journal of Development Economics 41, no. 1, 177-178.
ELSEVIER
Development ECONOMICS
Reply to White, ‘Foreign aid, taxes and public investment: A further comment’ Ira N. Gang a,*, Haider Ali Khan b aEconomics Department-NJH, Rutgers University, New Brunswick, NJ 08903-5055, USA b Graduate School of International Studies, University of Denoer, Denuer, CO 80210, USA Received May 1993
Our paper presented and estimated a rather straightforward model of policymaker behavior in examining how developing countries allocate the foreign aid they receive. In part, our contribution was methodological, refocussing the issue of aid impacts on intermediate short-run variables and shifting the study of aid impacts from cross-country to the analysis of behavior in a single country. The paper has many obvious shortcomings: the over-restrictive formulation of the policy-maker preference function and the constraints placed on their behavior, the difficulty in empirically measuring the theoretical variables including the formulation of the targets by policy-makers, the assumed exogeneity of aid, and interpreting time series estimates in light of the short-run nature of the theoretical model. Our compromises, we felt, were reasonable and we explicitly laid out all the steps we followed in hopes that others, if they found this approach interesting, would improve on our methodology. The comment by White illustrates some of these short-comings but does little to improve on our analysis. Here we highlight some of the major issues he raises. White repeats the valid theoretical criticism by Binh and McGillivray (1993) of the loss function we employed, though as we point our in our reply (Gang and Khan, 1993) their alternative loss function empirically works out to not including a constant term in our estimating equations. We also point out that the way forward is not through the problematic quadratic loss function but through the use of an asymmetric loss function, or more flexible functional forms,
* Corresponding
author.
0304-3878/94/$07.00 0 1994 Elsevier Science B.V. All rights reserved SSDI 0304.3878(94)00033-9
166
I.N. Gang, HA Khan/Journal
ofDecelopmenr Economics 45 (1994) 165-167
White argues that our specification of the budget constraint over-restricts recipient budgetary behavior - one would like the allocation of aid among budgetary categories to be the outcome of a utility maximizing problem. We obviously agree with him. Fungibility in this context relates to ex ante budgetary decisions of the recipient country. If the recipient plans to spend a certain amount of its own resources for a specific project, and thereafter receives foreign assistance tied to that project, such aid is fungible: the earlier earmarked funds can be allocated elsewhere. However, if the recipient conducts its budgetary exercise on the premise that certain programs will be funded by project aid, and if such aid actually materializes, the budget constraint remains unaltered. In this instance the project aid is not effectively fungible. Incorporating this behavior into a utility maximizing framework makes specification and estimation extremely difficult. Our specification is not without its problems, but at least it begins to capture some of the characteristics of policy-maker behavior. Use of a single budget constraint a priori assumes that aid is 100% fungible. White criticizes our implementation of the target variables on 3 grounds: it is ad hoc - a better approach is to model the targets as outcomes of a decision-making process; if our R2 is too high it indicates our targets are too closely related to our actual expenditures/ revenues; if our R2 is too low we cannot interpret the estimated coefficients as values of the targets. Again, we essentially agree with his criticism, and ask for an alternative specification and implementation. Our formulation was clearly a compromise, which, in fact, did not suffer the problem of having too high or too low an R2. White asserts we provide a misleading interpretation of the results by not reporting reduced form coefficients. Since our interest was in the recipient’s behavior, structural equation estimates were appropriate. To the extent that our language led the reader to infer anything else, we apologize. If one is interested in forecasting the impact of a change in aid on the particular variables in the system a reduced form estimation, such as a VAR, should be pursued. The dynamic aspects of the problem could then be fully incorporated. In White’s simulation reported in his Table 3, which involves converting our structural estimates to reduced form estimates by effectively inverting the relationship in our model (through iteration), he is able to obtain point estimates of the impact. However, from this procedure one cannot infer their significance. Finally, White argues “It therefore appears that Gang and Khan’s results are derived from the way in which the target series are estimated:. . . ” To this we happily admit, and even would go a step further and say that our results are derived from our specification of the policy-maker’s preference function and our formulation of the constraints, as well. Our work, and others, reveal that the results on fungibility turn out to be very sensitive to all aspects of the specification of the problem. Rather than telling us nothing about foreign aid, taxes and public investment, at the very minimum they demonstrate the possibility for systematic exploration of these issues. They also raise questions about the budgetary alloca-
IN Gang, HA
Khan/Journal
of Decelopment Economics 45 (1994) 165-l 67
tions. Whether the specific results can be relied on for policy purposes, matter.
167
is another
References Binh, Tran-Nam and Mark McGillivray, 1993, Foreign aid, taxes and public investment: A Comment, Journal of Development Economics 41, no. 1, 173-176. Gang, Ira N. and Haider Ali Khan, 1993, Reply to Tran-Nam Binh and Mark McGillivray: ‘Foreign Aid, Taxes and Public Investment: A Comment’, Journal of Development Economics 41, no. 1, 177-178.