Foreign Aid, Incentives and Efficiency: Can Foreign Aid Lead to Efficient Level of Investment?

This paper develops a two-period-two-country model in which an altruistic donor faces Samaritan’s Dilemma to address two important policy questions: (i) whether foreign aid can lead to efficient level of capital investment in the recipient country and (ii) how do the form (e.g. budgetary transfers, capital transfer) and the timing of aid affect the incentives of the recipient? It finds that the capital transfer makes financial savings more attractive relative to the capital investment for the recipient and exacerbates the free rider problem. The capital transfer can lead to efficient level of capital investment. But in this case, it completely crowds out the recipient’s own capital investment. In the absence of capital transfer, by using multi-period budgetary transfers the donor can achieve not only the efficient level of capital investment by the recipient, but also the allocation which arises when the donor can commit to its transfer policy. By tying its hands in the sense of forgoing capital transfer, the donor can give aid more efficiently.