Is Income Inequality Important for Foreign Aid Effectiveness?

Abstract This paper presents new evidence that foreign development aid only boosts growth in aid recipient countries with sufficiently low levels of income inequality, with less income inequality associated with better aid effectiveness. This finding holds irrespective of other determinants of aid effectiveness such as institutional quality, trade openness, budget balance, inflation, colonial history, geography and climate. I focus on aid intended to boost growth, by excluding categories of aid with other primary aims and by focusing on aid from OECD countries rather than China, India, Russia and the Gulf states. I use growth regressions using data on 53 countries over the years 1971-2015, controlling for numerous country-level factors previously associated with aid effectiveness. An increase of one standard deviation in the aid-to-GDP ratio is associated with nearly 2 percentage points of higher growth in the least unequal aid recipient countries but has no significant effect on growth in those recipient countries with inequality above the median level. The results are robust to sensitivity analysis using different control variables and specifications, and can be replicated using different estimators to address dynamic panel bias. This new evidence also supports the hypothesis, which I have developed in previous theoretical work, that economic inequality increases the power of rich elites to re-purpose aid expenditure in ways that further their own narrow economic interests. JEL Classification: F35 – O15 – O47 – O1 – O43