Foreign Aid and Income Inequality: Revisiting the Effectiveness of Foreign Aid

Abstract

This thesis uses a panel of 53 countries from 1984-2012 to measure the impact of foreign aid on income inequality. I use three separate models to evaluate which conditions in aid-recipient countries are conducive to effective aid. In each model, aid is interacted with one of three distinct measures of policy environment: level of democracy, attractiveness to investors, and political risk. It is hypothesized that increases in democracy and attractiveness to investors will increase the effectiveness of aid in combatting inequality while increases in political risk will mitigate the effectiveness of aid. I borrow methodology from the aid-growth literature that has yet to be applied to the aid-inequality nexus to provide an alternative to the use of questionable 3 instrumental variables used by a majority of papers in the literature. Specifically, after collapsing my panel into four-year periods, I use a simple lag of aid to address the issue of endogeneity in the aid-inequality relationship. I also corporate country and time fixed effects to control for omitted country-specific and time-specific variables. I find that aid does not unconditionally reduce inequality, but rather reduces it in some environments and exacerbates it in others. Specifically, aid to democratic countries significantly reduces inequality while aid to undemocratic countries increases inequality. Similarly, aid to countries with a pro-investment environment reduces inequality while aid to countries with a poor investment environment raises inequality. Finally, aid to politically risky countries increases inequality but has no effect in politically stable countries. Overall, my results serve to extend the limited literature on the relationship between aid and income inequality and qualify what conditions are conducive to effective aid. Given the World Bank’s recent focus on alleviating inequality as part of its plan for “sustainable development”, aid donors must consider how to allocate aid to effectively reduce inequality. Specifically, they should employ a synergistic approach of allocating aid contingent on conducive policy environments and encouraging positive policy reforms to make aid more effective in the future.