Aid loans versus aid grants: Are the effects different?

There is some debate regarding whether aid to poor recipients should be given in the form of loans or grants. This paper concentrates on whether the form of aid influences the effects on recipient fiscal behaviour. The main part of this paper investigates the recipient tax revenue response to inflows of aid and whether the composition of aid, i.e. loans or grants, induces a significantly different response. The relationship between aid and tax revenue is investigated for a sample of up to 55 low and middleincome countries over the period 1975-2000. The results indicate that there is no consistent and robust relationship between aid, the composition of aid, and the tax to GDP ratio in developing countries. This cross-country analysis is complemented by a time series study for 1964-2002 of the effect of fiscal variables (government expenditure and revenue) and aid on growth in Kenya. Two measures of aid are used; external grants and loans, and both yield different results. Aid loans are found to have a negative impact on long run growth, while grants have a positive, albeit weak, impact on growth. The paper concludes that, at least for poor recipients, grants are to be preferred to loans because they create no future repayment burden and appear not to have adverse fiscal effects.