Democratic Reforms, Foreign Aid and Production Inefficiency

We construct an endogenous growth model and we employ empirical analysis to investigate the link between foreign aid and production inefficiency in the presence of different political orientations in the recipient country. Using a panel of 124 countries from 1971 to 2007 and the production frontier toolbox, controlling for unobserved heterogeneity, time horizons, the sources of aid, and the timing of aid impact, we document that foreign aid is associated with higher production inefficiency and that this inefficiency is reduced considerably if countries switch to democratic governance. Our study contributes to the aid literature by pointing to the institutional enhancement of the recipient countries through the adoption of democratic ruling practices. JEL Classification: C01, D24, F35, O43.