Foreign Aid and Fiscal Policy in a Small-Open Economy with a Non-Market Sector
| Author | Naiyue Cui,Yunfang Hu |
| DOI | http://doi.org/10.1177/00157325221128654 |
| Published date | 01 February 2023 |
| Date | 01 February 2023 |
| Subject Matter | Articles |
Foreign Aid and Fiscal
Policy in a Small-Open
Economy with a
Non-Market Sector
Naiyue Cui1 and Yunfang Hu1
Abstract
This study examines the macroeconomic effects of foreign aid and fiscal policy
by employing a multi-sector growth model. Foreign aid may decrease the recipi-
ent country’s market activities by lowering its capital accumulation and shifting
market labour and capital to the non-market sector. This market activity shift-
ing can improve the recipient country’s foreign asset/debt position where real
exchange rate plays a role. We examine fiscal policies’ long- and short-run impacts
and the recipient country’s administration efficiency in handling aid. Efficiency
improvements in the recipient country’s governance of foreign aid can lower its
real exchange rate, thereby contribute to improving foreign asset/debt holdings.
Although administration costs in foreign aid may cause losses, by raising both mar-
ket and non-market goods consumption, foreign aid improves the welfare of the
recipient country. Our numerical analysis demonstrates the comparative statics
and comparative dynamics impacts of several fiscal policy experiments. We illus-
trate that capital and labour income’s taxation effects can be very different.
Keywords
Foreign aid, fiscal policy, non-market sector, administration efficiency
Introduction
The effects of foreign aid on the recipient economy’s development is one of the
most discussed topics. Empirical studies emphasise the importance of policy gov-
ernance in recipient countries (see Burnside & Dollar, 2000; Easterly, 2003).
In other words, the government is essential in determining how foreign aid can
impact the recipient country’s performance. This study examines how the efficiency
Article
Foreign Trade Review
58(1) 144–175, 2023
© 2022 Indian Institute of
Foreign Trade
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DOI: 10.1177/00157325221128654
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1 Graduate School of Economics, Kobe University, Kobe, Hyogo, Japan.
Corresponding author:
Yunfang Hu, Graduate School of Economics, Kobe University, 2-1, Rokkodai-cho, Nada-ku, Kobe,
Hyogo 657-8501, Japan.
E-mail: yhu@econ.kobe-u.ac.jp
Cui and Hu 145
of foreign aid use can impact a fiscal-policy-distorted economy by constructing a
small-open economy model with a non-taxable sector. By raising the share of for-
eign aid used for market activities, we explore the effects of governance efficiency
improvement on the recipient country’s foreign debt holding, investment and labour/
capital allocation between the market and non-market sectors.
The welfare effects of foreign aid have long been discussed in the field of inter-
national trade.1 In particular, after the prominent work of Kemp and Kojima (1985),
a large body of studies has contributed to the tied aid literature under a competitive
two-country framework.2 The literature also explores the importance of governance.
For example, Kemp and Wong (1993) discuss the paradoxical effects of tied aid by
paying attention to the administrative costs related to foreign aid.
Among others, Chatterjee et al. (2022) illustrated the new impacts of foreign aid
by constructing a small open economy with an informal sector. They assume that
foreign aid may enhance a recipient country’s investment activity in the case of tied
aid.3 In contrast to their model setting, we assume separate tax rates for labour and
capital income, which can help us understand the policy impacts more closely.
This study employs a small open economy model with a non-market household
production sector. We assume that untied foreign aid helps to enhance the recipi-
ent country’s budget constraints. Like Kemp and Wong (1993), we also discuss
governance efficiency in administrating foreign aid. In contrast to Kemp and
Wong (1993), however, this study employs a dynamic framework. Since incomes
from labour and capital are taxed separately in this study; we can compare their
impacts on resource allocation and outputs.4
The main findings are as follows: foreign aid may decrease the recipient coun-
try’s market activities by lowering its capital accumulation and shifting market
labour and capital to the non-market sector. This is similar to the Dutch Disease
effect in Chatterjee et al. (2022). However, foreign aid can improve the recipient
country’s foreign asset/debt position through the market shifting and the real
exchange rate impact. We further explore the impacts of the recipient country’s
administrative efficiency on handling aid. For example, a recipient country’s gov-
ernance efficiency improvement can decrease its market activities and lower its
real exchange rate, thereby improving foreign asset/debt holdings. By raising both
market and non-market goods consumption, foreign aid, even with administrative
costs, can still improve the welfare of the recipient country. This differs from the
paradoxical effects of Kemp and Wong (1993). Our numerical analysis illustrates
several fiscal policy experiments’ comparative statics and transitional dynamic
effects. For example, an increase in the labour income rate raises the recipient
country’s exchange rate and weakens its improvements on the foreign asset hold-
ings in the long run. However, the long-run effects of capital income taxation can
have opposite impacts on exchange rates and foreign assets. This asymmetry in
capital and labour income taxation differs from the related literature. In general,
owing to an untaxable non-market sector, taxation decreases market labour, capi-
tal, and consumption but raises that of the non-market sector.
The remainder of this article is organised as follows: in the second section, we
construct an analytical framework for the base model; the third, fourth and fifth
sections are for the theoretical dynamic analysis and policy application; and we
conduct a numerical analysis in the sixth section
146 Foreign Trade Review 58(1)
The Base Model
Time is continuous. The agents live infinitely from 0 to ∞. We consider a small
open economy in which many homogenous households dwell. By normalising the
population size to one, we can use the same notations to represent the aggregate
and individual variables. As production factor’s owner, the representative house-
hold can supply its physical capital Kt to either the market sector or the non-
market (home) sector. At each instant, t, the household allocates their constant
labour L(= 1) between market working Lmt, non-market working Lht and leisure nt
time, respectively. The market sector supplies consumable investment goods,
where non-market goods can only be consumed at home. All markets, including
final goods and factors, are perfectly competitive.
Market and Non-market Sector
We denote the variables in the market and non-market sectors with the subscripts
of m and h, respectively. We assume that standard constant-returns-to-scale neo-
classical production technologies prevail in the market and non-market sectors.
Specifically, the production function in sector-j is YAKL jmh
jt jjtjt
jj
1
,,
where Aj is a productivity parameter, Kjt and Ljt are the physical and labour inputs
to sector-j. Using the form of the capital/labour ratio
xKL
jt jt jt
=/
,output in sec-
tor-j is YALx
jt jj
tj
t
j
. Hence, the returns to capital and labor in the market sector
are as follows:
R
Y
K
Ax w
Y
L
Ax
t
mt
mt
mmmt t
mt
mt
mm
mt
mm
11
,.
(1)
Both capital and labour can move freely between sectors. Full employment condi-
tions for capital and labour at each instant t are as follows:
1
LLn
mt ht t
; (2)
KK K
tm
th
t
.
(3)
Households
For a given initial capital K0 and asset (or debt) holding A0, and all prices and tax
rates, the representative household chooses consumption sequences cmt, cht, labor
supply/leisure nt to maximise their lifetime utility:
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