This paper surveys the literature on the two-way relationship between development aid and the quality of institutions in developing countries. Aid may improve institutions, e.g. when conditionality succeeds, but it can also have unintended effects that are typically negative, e.g. by inducing rent seeking. The direction of causality is the other way around when the quality of institutions in developing countries is taking into account by donors when they allocate aid between countries.
The paper presents a canonical model as a framework for analysing such effects. The key elements in this framework are the differences between donor preferences and those of the recipient government, the extent to which the ruling elite in the recipient country cares about the poor, and the cost of taxation. The paper then discusses both the theoretical and empirical literature on aid and institutions, a subset of the literature on aid effectiveness. The discussion uses the model and is structured around the two roles of aid: aid as finance and aid as reform. The paper focuses on the way aid is allocated between countries and delivered within a country (that is with what forms of conditionality and monitoring) affects outcomes such as poverty. It concludes that the empirical and theoretical literature are imperfectly matched. This suggests useful directions for future research.
Author(s): Jan Willem Gunning and François Bourguignon