ODA is not dead

Many discussions on global development highlight that public aid flows to developing countries are now dwarfed by private flows in the form of foreign investments and remittances from emigrant workers. The suggestion of many commenters, either implicit or explicit, is that public aid flows are becoming irrelevant.

Are they?

We don’t think so. Private flows are not a substitute for aid in developing the world’s poorest countries, because private flows, as we will show, do not greatly increase the supply of public goods and services.

We examined worldwide figures on official development assistance, remittances and foreign investment for analysis. Foreign investment and remittances do far exceed ODA, i.e., public aid, in overall amounts.

As the figure shows, combined foreign investment and remittances in 2011 (the latest available data) were more than seven times larger than aid for all developing countries. Looking only at the least developed countries, private flows were roughly equal to official ones: Aid amounted to $45 billion in 2011, while foreign investment and remittances totaled $49 billion.

But this comparison of total amounts does not tell the whole story. Whether this disparity makes aid irrelevant depends on what effects of financial flows you consider.

One impact of financial flows into a country is to generate economic demand and growth. The flows act as an “economic stimulus package”: People receiving the money have more to spend, which increases the income for other people and hence their spending, and so on. For this impact, it doesn’t matter much where the money comes from, at least in the short term. Hence, private flows are indeed becoming more important than aid, even in least-developed countries, as a stimulus for increasing economic activity.

A second impact, however, is to provide people with services, such as health, education, housing and sanitation. Remittances enable recipients to purchase these services themselves. Foreign private investments will typically result in some local employment and consequently enable employees to acquire these services as well. But only aid directly finances improvements in access to and quality of such public services.

For example, U.S. company Procter & Gamble recently opened a new factory in Nigeria. This private investment will employ workers and likely raise their incomes. These workers and their families will be able to access improved services, either because they can afford private education or health care, or if the company provides some services directly to its workers. However, the investment will not likely have direct effects on public services for the general Nigerian public, such as upgrading schools or hiring more doctors and nurses for public clinics. By contrast, U.S. Agency for International Development support helps strengthen the country’s educational system through teacher training programs and infrastructure improvement.

Private flows only contribute to public social services to the extent that they generate increased tax proceeds — and these are a very small share of the private flows. Foreign investments are not taxed as such; only profits and wages of workers hired are taxed. In many cases, profits on foreign investments are untaxed, and governments sometimes even subsidize foreign investment.

According to Stephen Kosack and Jennifer Tobin, “no one is totally sure if FDI does in fact increase or decrease tax revenue.” The vast majority of remittances are not taxed, and only sales or value-added taxes on purchases with remitted funds would generate additional public revenue. If, say, 25 percent of private flows are taxed in some way, and at an average rate of 20 percent, then total taxes on private flows would be 5 percent of the flows — and it is very unlikely that many developing country governments collect even this much tax revenue on foreign investments and remittances.

Consequently, private flows do not greatly enhance public services. They have much less of an impact on public service provision than ODA from foreign aid programs.

Of course, it is not certain that aid flows to developing countries always result in improved social services. Aid money may be used inefficiently or incorrectly.

Kozack and Tobin have conducted interesting statistical tests on many of these questions. They find generally that aid has some effects on human development, especially in democracies — in which presumably accountability to the public makes it more likely that aid goes to human development spending — and that foreign investment has had limited effects on human development or, perhaps more surprisingly, growth.

In conclusion, we believe that it is not very useful to compare total amounts of official aid with total amounts of foreign investment or remittances. All three are important. Foreign investment has helped several countries escape poverty through the economic growth that successful industries bring over time. Remittances make a huge difference to the lives of the recipients. Official aid is critical for improving public services and meeting basic human development needs, and aid will remain the most important source of foreign financing for such services for a long time to come.

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