Effects of Foreign Aid on Public Expenditure

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1.1 Background to the study

Foreign aid represents an important source of finance in most developing countries. It is estimated that foreign aid accounts for about 10 percent of the GDP and 40 – 70 percent of the government’s annual expenditure budget in Sub-Saharan Africa (SSA). It is estimated that over 90 percent of foreign aid projects in Sub-Saharan Africa (SSA) are implemented by foreign consulting firms. Critics of argue that foreign aid substitutes domestic resources through declined savings, reduced government tax revenue and increased government consumption. Aid reduces fiscal deficit in these countries and sets free other resources which can be utilized for debt service and other expenditures. There is need to analyze the effects of aid on the budget process by establishing the link between foreign aid and public expenditure. In spite of this massive foreign aid, developing countries are still poor today. In fact, no amount of foreign aid to a developing country like Uganda will solve its development predicament without addressing the core fiscal constraints facing the country, which are more often a result of misdirected or extravagant public expenditure projects, weaknesses in tax administration and corruption. The amount of annual public revenue lost through these loopholes is probably three to five times the foreign aid inflows. Uganda is a country hailed by international donors, especially the World Bank and the International Monetary Fund, as an African economic success story. The country depends on foreign aid for nearly 50 percent of her budget which has now been reduced to nearly 33 percent in the current financial year .Foreign aid is important in Uganda because it finances free primary education, free basic health care, and infrastructure rehabilitation and maintenance. However, is it true that without foreign aid Uganda would lack revenue to meet those public expenditure needs? Uganda has had a large proportion of government-to-government aid channeled through the budget in more recent years, but even so, this is still less than 50% of all aid to Uganda. And in that regard, there are just as important questions about programme and project aid as there are about aid flowing through a government's budget - mostly around issues of sustainability, of fragmentation, of creating "islands of excellence" without addressing the deep-rooted systemic issues. [pic][pic][pic]As to aid which is delivered through government systems, the close attention to the integrity of that funding, ensuring that it reaches the poorest, and that it delivers real and tangible results, is uppermost in our minds. Far from being an "easy way to get rid of aid", supporting the budget is a complex, resource-intensive and closely monitored process. Studies on the effects of foreign aid on savings and growth in developing countries, besides having made a good case for increased flow of foreign aid, raise questions on the utilization of these funds on their designated projects (White 1992). The donor community has become increasingly concerned that part of the development assistance intended for crucial projects finances projects other than those earmarked for funding. For example a study by Uganda Debt Relief Network (2000) revealed that only 35% of the external funds reaches the designated targets, under scoring the notion that aid to developing countries is fungible. This may imply that aid recipient governments view foreign aid like any other source of revenue and consequently use it for increased consumption, tax reductions or reduced fiscal deficits (future tax obligations). An interesting question would be what proportion of increased spending resulting from increased donor funds goes to either recurrent or development expenditures. The answer can shed some light on the implications of an aid freeze to recipient countries, and highlight how governments in developing countries respond to fiscal...
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