Where Has All the Money Gone? Foreign Aid and the Composition of Government Spending

This paper examines the link between foreign aid and the composition of government spending in aid-recipient countries. Two questions are addressed: (i) does foreign aid crowd out government spending in aid-recipient countries, and (ii) does the degree of fungibility vary across different categories of aid? Using a panel dataset of 67 countries for 1972-2000 we find that at the aggregate level about 70 percent of total aid is fungible. We also find that aid targeted for public investment crowds out about 80-90 percent of domestic government spending on public investment. Aid does not affect private investment, but has a strong positive impact on household consumption. The results are also robust to checks for causality. These findings are significant, since more than two-thirds of all aid flows to developing countries are tied to public investment projects.