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The Fiscal Effects of Aid in Malawi

Working papers

The aid effectiveness literature has shown that aid to developing countries tends, on balance, to have a positive effect on growth, though results are sensitive to the econometric method adopted. In recent years, the literature has concentrated on the relative importance of policy and other variables for aid effectiveness, and has less to say about how aid itself affects policy and specifically about the effects of aid on fiscal policy. Aid can affect economic growth, for instance, via its impact on government behaviour, investment and savings. Government consumption or current expenditure can also raise growth, by increasing the general level of economic activity. As much of aid is usually given to the government, its effects on growth and poverty are likely to be primarily mediated by government fiscal policy.This paper studies the impacts of aid on fiscal aggregates in Malawi over the period 1970-2000. The existing research on the fiscal impact of aid can be divided into two categories. The fungibility literature concentrates on whether aid is spent on those sectors where it was intended, such as health and education. The fiscal response literature goes beyond issues of fungibility by analysing the impact of aid on fiscal aggregates such as tax revenue, total spending, public investment (development expenditure), public consumption (recurrent expenditure) and domestic borrowing. It also examines the impacts in a dynamic framework, in contrast to the fungibility literature, which tends to concentrate on static effects. The evidence from the two types of literature suggests that aid can have significant impacts on fiscal aggregates and budgetary planning, but it is difficult to generalise and the actual effects remain rather country-specific. In this paper we assess the effects of aid on the two types of domestic borrowing and tax revenue as well as on total expenditure and the two expenditure categories: recurrent and development spending.

To date, much of the fiscal response literature has used structural econometric models, which can be difficult to estimate. In order to circumvent this problem, this paper uses a vector error correction (VEC) framework to analyse the effects of aid on fiscal aggregates in Malawi. In so doing, it follows in the footsteps of Osei and Morrissey (2003), who have modelled the fiscal effects of aid for Ghana using a vector autoregression (VAR) model. This approach takes into account the interactions between fiscal variables over time and treats the variables as endogenous. It is an atheoretical approach in the sense that it does not test specific theoretical formulations of budgetary planning, which could constrain the scope of the analysis. The fiscal response and fungibility studies, on the other hand, start from the viewpoint of utility maximisation. In the former, the government maximises utility based on a quadratic loss function and subject to targets for each revenue and expenditure category. However, concerns can be raised about the type of budget decision-making process modelled, which in reality is unlikely to be as stable or consistent. In real life, expenditure tends to be firstly allocated to mandatory categories and, subject to further financial availability, used thereafter for more discretionary programmes. This type of setting could be catered for, for instance by a Stone-Geary utility function that results in a linear expenditure system, where expenditure on an item consists of a predetermined amount plus an addition, where the latter depends on the availability of funds. This theoretical option, however, focuses on expenditure and cannot be used to assess the effects of aid on other forms of financing or to account for the fact that different forms of finance may be used for different type of expenditure.

In this paper, we do not opt for an alternative theoretical formulation, but rather wish to take into account the interactions between fiscal variables that can be rather complex to model theoretically. We therefore choose to use a VEC framework instead of a standard VAR, as the fiscal variables were found to be non-stationary and cointegrated.

Before embarking on the econometric analysis, the paper discusses movements in aid and fiscal aggregates in Malawi and the political economy background to fiscal policy. The 1970s was a relatively good economic period in Malawi, with fairly high GDP and investment growth. However, there was excessive recourse to foreign loans to finance prestige projects and enterprises, leading to debt-service default. Thus in the 1980s fiscal management and economic conditions worsened, partly triggered by a series of external shocks (terms of trade and war in neighbouring Mozambique), debt and poor domestic policy. The country has since repeatedly resorted to supplementary budgets, and domestic borrowing increased to cover excess expenditures. In 1981, Malawi started its first structural adjustment programme supported by the World Bank and the IMF. Despite the wide range of reforms implemented, sustained growth proved elusive. The 1990s was a volatile period, partly driven by the transition to democracy as well as the many IMF-supported reforms. Droughts, interest payments on debt, the weak performance of parastatals and commodity price fluctuations all complicated fiscal management. Since the mid-1980s and the advent of structural adjustment loans and conditionality, donors have on several occasions withdrawn assistance because of non-compliance. Before the late 1990s, decisions about the development and recurrent budgets were formulated by separate institutions. The development budget has been largely donor-financed, but its composition has changed throughout the years as recurrent spending items are increasingly allocated to the development budget. Similarly, the recurrent budget entails items that one would expect to find in the development budget. The classification of the budget has therefore been more institutional than strictly economic.

Although some hypotheses could be formulated on the possible indirect impacts on growth and poverty, the focus of this study is on the impact of aid on fiscal variables. The VEC approach can also be used to determine whether aid reacts to budgetary imbalances.

The following hypotheses are tested:

# Does aid discourage tax effort? The implications of this scenario can be country-specific, depending on the degree of tax effort. Tax effort in Malawi has not been weak. Earlier empirical studies have shown that aid can undermine domestic revenue mobilisation, but there is also evidence pointing in the other direction. If aid discourages tax effort, it can, however, perpetuate or even increase aid dependency.

# What is the impact of aid on domestic borrowing? Does aid increase or substitute for domestic borrowing? This can have implications for macroeconomic stability. Net domestic borrowing was positive in Malawi throughout the 1970s and a large part of the 1980s. However, partly due to donor requirements, net domestic borrowing has been negative on several occasions since the late 1980s, but also somewhat more volatile.

# How does aid affect government expenditure? In particular, does aid lead to more than proportional increases in total expenditure? This could happen, for instance, because of aid illusion, a situation where the government misperceives the actual value of the aid inflow, or the spending conditions attached to the inflow (McGillivray and Morrissey (2000)). This might arise in an environment of imperfect information and weak public expenditure management. One possibility is that the aid, on which the government bases its spending plans, fails to be disbursed. This has been the case in Malawi on a few occasions, at least in the 1990s.

# What happens to the composition of expenditure as a result of aid? In this study the focus is restricted to the recurrent/development expenditure divide, so the effect of aid on expenditure is not investigated at a more disaggregated level, as is done in fungibility studies. Some consideration is given to whether aid funds the types of expenditures that reduce poverty, either directly through pro-poor spending, or indirectly by stimulating investment spending and growth. However, care is required in making assumptions about the growth effects of development and recurrent expenditure, as the distinction is not straightforward. We expect the institutional divide between the recurrent and development budgets to be reflected in the results.

# Finally, can the empirical approach reveal anything about the budgetary process? Is aid given to alleviate imbalances in the budget?

Three VEC models are estimated. The first is used to estimate the impact of an increase in grants and the second the impact of an increase in net foreign loans on the other fiscal variables. The effects of the two types of external financing are estimated separately both for technical and economically justifiable reasons. An additional model that identifies the effects of official development assistance (ODA) is also estimated in order to approximate the joint impact of both foreign loans and grants, but also as an attempt to capture the effects of off-budgetary aid on the budget. Due to a growing part of aid being off-budget from the mid-1980s onwards, ODA flows are substantially higher than the sum of net foreign loans and grants recorded in budgetary operations. In the analysis, no distinction could be made between concessional and non-concessional foreign loans, as data were not available for the entire period.

The models succeed in capturing many of the features of the budgetary process and planning in Malawi. The results coincide largely with the hypotheses made on the impacts of external financing. The final conclusions about the effects of external financing are based on generalised impulse response functions that depict the total effect on fiscal aggregates over a number of years, as a result of a permanent increase in external financing.

The general conclusions are that, whatever the type of external financing, an increase in external financing:

# has a positive long-run impact on the development budget,

# has a negative long-run effect on domestic borrowing, and

# does not discourage tax effort.

The impact on the recurrent budget, on the other hand, depends on the type of external finance.

The results of an increase in grants are quite similar to those of an increase in ODA. In the long run, an increase in both boosts the development budget and leads to a fall in the recurrent budget. The latter may appear somewhat unexpected, but is partly due to the fact that the grant inflow leads to a fall in domestic borrowing. The recurrent budget is shown to be largely domestically funded. The result suggests that part of the increase in grants is used to reduce net domestic borrowing, which can be partly explained by compliance with donor requirements. The fall in recurrent budget expenditure could also be caused by the increasing tendency to allocate items of a recurrent nature to the development budget.

These expenditure effects of an increase in ODA or grants confirm the dual nature of budgetary planning in Malawi. They also suggest that the theoretical approach of the fiscal response literature, where governments maximise utility subject to targets, might not be the appropriate framework for modelling the budget process in Malawi. This issue is discussed in more detail in the accompanying synthesis paper (Fagernäs and Roberts, 2004a). The model results for ODA and grants also reveal something about the nature of budgetary planning in Malawi. Domestic borrowing or aid has been a financing item of last resort, and spending plans are not reduced in response to previous year imbalances in the budget.

An increase in grants and ODA does initially raise total expenditure, but not over-proportionally to the increase in grants. The increase also lowers domestic borrowing, but does not discourage tax effort. Overall, an increase in grants and ODA appears to have a largely positive fiscal impact, although the fall in recurrent expenditure needs to be assessed in the light of the type of expenditure affected. Since the beginning of the 1990s, the composition of expenditure has changed in a largely pro-poor way, as the share of social expenditure in recurrent expenditure has risen. The fall in domestic borrowing is likely to have a positive economic effect, if it induces more macroeconomic stability.

The long-run effects of an increase in net foreign loans are otherwise similar to those of grants and ODA, except for an increase in recurrent expenditure. This may reflect the differences in the nature of foreign loans and grants, especially in the 1970s and early 1980s, when a considerable amount of foreign loans were granted on non-concessional terms.

Unlike grants, foreign loans are affected by lagged movements in other fiscal variables. As already mentioned, there is also evidence that ODA has been provided for the purpose of facilitating fiscal adjustment. Therefore, the analysis suggests that decisions on external financing can be affected by past fiscal policy and past movements in fiscal aggregates.

External financing clearly drives the development budget, but it is somewhat difficult to establish conclusions about the desirability of this result in terms of growth or poverty reduction. In the 1970s, the development budget consisted almost entirely of capital expenditure. Although capital formation is still the largest item, the composition of this budget has changed throughout the years, as items of a 'recurrent' nature, such as wages and goods and services, have captured a notable share. Much of development expenditure is foreign-funded, but an assessment of multilateral aid in Malawi in the 1990s concludes that investment lending has often not succeeded in meeting its objectives and has on many occasions been irrelevant and the impact has not been sustained. This suggests that capital expenditure may not have been very effective. However, the share of education and health in development expenditure has on average doubled between the periods 1977-88 and 1989-2000. Figures on bilateral aid flows also suggest that aid has been allocated increasingly towards the social sectors in contrast with the heavy orientation towards the economic and agricultural sectors in the 1970s and early 1980s. If increases in aid inflows lead to higher social expenditure, this should feed into long-run growth, if used effectively. However, a rather large share of development budget expenditure is still being devoted to administration.

The methodology used has enabled us to obtain a number of interesting insights into both the effects of aid on fiscal variables and the budgetary process in Malawi. There are, however, some caveats. Relying on generalised impulse responses to assess the full effect of an increase in aid implies that there will also be a contemporaneous shock to other fiscal variables. Therefore, it can be difficult to extract the effects arising purely from the aid shock. Some of the models tend to be somewhat over-parameterised, and applying restrictions on certain parameters could have improved the accuracy of the results. A more in-depth analysis of the time series properties of the variables and possible structural breaks, would have added to this. It must also be acknowledged that the model results, particularly those of model 3, are somewhat sensitive to model specification and thus not entirely robust. Parallel case studies on the fiscal impact of aid in Uganda and Zambia (Fagernäs and Roberts, 2004b, 2004c), using the same methodology, however, result in broadly similar conclusions on the effects on expenditure and domestic borrowing, but the impact on domestic revenue varies.

Sonja Fagernas and Cedrik Schurich