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A substantial amount of aid to developing countries is given to the government, or goes through the budget, meaning it should have an impact on government fiscal behaviour (particularly on government spending). The few existing cross-country empirical studies on the effects of aid on government spending neglect time series properties, cross-country (recipient) heterogeneity and the potential for cross-country correlation. This paper examines the impact of foreign aid and taxes on government spending for a sample of 69 developing countries over 1980-2013, taking account of dynamics characterising fiscal data, cross-country heterogeneity and the distorting impact of cross-section dependence, by applying the Pesaran (2006) CCE Mean Group estimator. We show that spending, net aid (as well as variants including grants and loans) and taxes comprise an equilibrium (cointegrated) relation. Our results provide robust evidence of a positive, long-run (as well as short-run) association between aid and spending. On average, the aid coefficients are positive but smaller than the tax coefficients, indicating that in the long-run and short-run taxes have a stronger association with expenditures than aid.

The main argument of this paper is that there is considerable heterogeneity in the way aid can shape tax performance in developing countries: through behavioural effects, donor conditionality, recipient policy reform and technical assistance; and these effects are country-specific. We investigate these effects by applying the dynamic Common Correlated Effects Mean Group estimator to a dataset comprising 84 developing countries from 1980 to 2013. The following results ensued: aid and taxes comprise an equilibrium relation, with a positive long-run association between aid and taxes; causality runs from aid to taxes, suggesting that on average, changes in aid induce permanent changes in taxes.