Fiscal Effects of Foreign Aid in a Federal System of Governance The Case of India

Abstract:     
This paper models fiscal effects of foreign aid in a federal system of governance. Our main innovation is to incorporate the
inter-governmental fiscal link in examining economic fungibility of foreign aid. The model is applied to the expenditure decisions
of the central government of India. The two main findings are: (i) Foreign aid merely substitutes for spending that the
government would have undertaken anyway; funds freed by aid are spent on non-development activities, and (ii) In passing
earmarked external assistance to states, the central government makes a reduction in its transfers to states. These findings
indicate that the central government's expenditure choices are unaffected by external assistance. The implication for donors is
that even though their development projects may be associated with very high rates of economic return, they could be assisting
the central government in financing something very different at the margin. For the state governments, the finding indicates that
they may not be reaping the full benefits of externally procured assistance.

Keywords: Foreign aid, Federal system, Fungibility, Development and non-development government expenditures, India

JEL Classification: E62, O23

Accepted Paper Series