Aid illusion and public sector fiscal behaviour

Two findings have been common in the literature on the impact of foreign aid on public sector fiscal behaviour in developing countries. The first is that aid ‘sticks’ to higher levels of recipient government expenditure, with aggregate expenditure often rising by more than the value of the aid inflow. The second is that aid is often associated with declines in taxation revenue. This paper, using insights from public choice research on fiscal illusion, provides a number of theoretical scenarios in which the first of these outcomes arises, but which also allow for simultaneous reductions in taxation. In contrast to the arguments regarding fungibility in Assessing Aid we present scenarios where, even assuming that donors and recipients are agreed on how aid should be allocated to expenditure headings, apparent fungibility will arise. The paper concludes by suggesting new directions for research on the impact of aid on the public sector in developing countries.