Foreign aid’s impact on domestic business climates. An empirical analysis with SSA and MENA countries
| Published date | 07 November 2016 |
| Pages | 365-382 |
| DOI | https://doi.org/10.1108/JEPP-06-2016-0023 |
| Date | 07 November 2016 |
| Author | Nabamita Dutta,Russell S. Sobel,Sanjukta Roy |
| Subject Matter | Strategy,Entrepreneurship,Business climate/policy |
Foreign aid’s impact on domestic
business climates
An empirical analysis with
SSA and MENA countries
Nabamita Dutta
Department of Economics, College of Business Administration,
University of Wisconsin-La Crosse, La Crosse, Wisconsin, USA
Russell S. Sobel
School of Business, The Citadel, Charleston, South Carolina, USA, and
Sanjukta Roy
The World Bank, New Delhi, India
Abstract
Purpose –Existing literature has expressed significant pessimism about the outcomes of foreign aid
received by developing nations. Foreign aid can lead to negative outcomes by generating greater
rent-seeking opportunities and creating aid dependence. While aid’s negative impact has been explored
in the context of growth, political institutions, and economic institutions, the literature has not
investigated the effect of aid on business climate of recipient nations. The purpose of this paper is to
explore foreign aid’s impact on government regulations on the business climate in Sub-Saharan
African (SSA) and Middle East and North American countries.
Design/methodology/approach –The authors consider a panel of 64 countries over six years. Since
foreign aid is most likely to be endogenous, as identified in most studies, the identification strategy
follows two methodologies –system GMM estimator, that creates its own instruments via moment
generating conditions and instrumental variable approach that relies on an external instrument.
Findings –The authors find that aid worsens the business climate by increasing government
restrictions. Foreign aid provides the recipient governments and the political elite resources to
strengthen their power and reinforce predatory policies that are harmful for the business climate.
The results further show that in the presence of long-lasting and sustainable democratic regimes, the
negative impact of foreign aid on business climate mitigates to a certain extent.
Originality/value –While aid’s negative impact has been explored in the context of growth, political
institutions, and economic institutions, the literature has not investigated the effect of aid on business
climate of recipient nations. The authors explore the impact of foreign aid on government regulations
on the business climate in SSA and Middle East and North American countries.
Keywords Entrepreneurship, Foreign aid, MENA, SSA, Business climate, Political institutions
Paper type Research paper
1. Introduction
While aid may be given with the intention of helping to improve institutions in the
recipient country, the literature points to many reasons why the impact may be just the
opposite. Bauer (2000), for example, argues that aid suffers from an important
asymmetry. Aid is generally a very small percentage of national income, thus it
has limited capacity to improve poverty levels; however, it can be a large percentage
of the recipient government’s budget for funding discretionary spending. With
government less reliant on domestic revenue sources and more heavily reliant on less
transparent aid funding, it can increase corruption, concentrate political power, an d
lead to a movement toward greater dictatorship (see de Mesquita and Smith, 2009;
Journal of Entrepreneurship and
Public Policy
Vol. 5 No. 3, 2016
pp. 365-382
©Emerald Group Publis hing Limited
2045-2101
DOI 10.1108/JEPP-06-2016-0023
Received 16 June 2016
Revised 16 July 2016
Accepted 17 July 2016
The current issue and full text archive of this journal is available on Emerald Insight at:
www.emeraldinsight.com/2045-2101.htm
365
Foreign aid’s
impact
Smith, 2008; Djankov et al., 2006; Rajan and Subramanian, 2007a, b; Bräutigam and
Knack, 2004; Bauer, 2000). Studies that test Bauer’s hypothesis, such as that by
Djankov et al. (2006), find that aid weakens democracy in the recipient country to
a greater extent than does the popularized “resource curse”[1]. Following this strand of
literature, we explore foreign aid’s impact on the domestic business climate of recipient
nations employing various measures of business regulations.
A recipient government’s internal regulation of business is an important link in the
understanding of how aid may impact economic outcomes. Regulations not only suffer
from Hayek’s (1945) knowledge problems that plague all central-planning efforts but
also reduce the rate of entrepreneurship, and thus hamper creative destruction and the
market discovery process (see Schumpeter, 1942; Hayek, 2002). Entrepreneurshi p –the
experimentation of new business ventures –is a key source of economic progress.
Through a process of trial and error, entrepreneurs search for new combinations of
resources that may produce more value than the alternatives that can be produced with
those resources. Economic progress is highly dependent upon the use of the
competitive market process to discover the best use of resources through
entrepreneurial experimentation, knowledge that cannot be determined without the
process taking place (see Hayek, 2002). By interfering with this competitive discovery
process of creative destruction, higher regulations lead to worse economic performance.
The argument from the previous literature holds that aid can make governments
less dependent on internal tax revenue. In doing so, it reduces the government’s
incentive to care about the level of domestic economic activity as the revenue from
taxing is not as important to finance government activities. A regulation that lowers
entrepreneurship, and thereby shrinks economic activity, normally costs the
government important tax revenue. When tax revenue becomes a lower share of
government receipts, essentially it reduces the tax cost of imposing harmful regulations
to the domestic government. This indeed may be the channel through which aid causes
a deterioration in economic freedom, as the aid reduces the “price”of imposing bad
policies that reduce economic activity. This is the link we intend to test here.
An extensive literature has explored the impact of higher regulations on
entrepreneurship rates. Costly regulations obstruct the creation of new firms and are
most damaging for industries that normally experience high-entry rates. Ardagna and
Lusardi (2011) have explore the interlinkages between entry regulations, contract
enforcement regulations, and financial development on the decision to become an
entrepreneur and the level of employment in new ventures. They find that even after
controlling for financial development, entry regulations deter entrepreneurship. Using
a two-equation model, van Stel et al. (2007) show that entry regulations, in the form of
minimum capital requirement to start a business, harm entrepreneurship rates. Cebula
et al. (2016) find that entrepreneurship is promoted by greater economic freedom –
which implies less government interference in private market economic activity.
There are two obvious theoretical reasons why higher levels of aid may lead to
higher levels of internal business regulation. First, as pointed out above, by weakening
the government’s relative dependence on tax revenue from productive, domestic
economic activity, it lowers their interest in maximizing the size of the internal
economic pie. Second, because aid itself is a centrally planned, top-down policy, it
encourages the development of skilled political agents and policies that use this
approach to manage the entire economy. Foreign aid distribution in essence is similar
to Soviet-style central planning and is subject to all of the same knowledge problems
(see Boone, 1996; Svensson, 1999, 2000; Knack, 2001; Brumm, 2003; Ovaska, 2003;
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