Essays on sub-optimal fiscal policy responses in sub-Saharan African countries

• Main Author: Kufuor, Nana Kwabena
• Published: University of Nottingham 2012
• Subjects: 339.5; HJ Public finance
• Online Access: http://ethos.bl.uk/OrderDetails.do?uin=uk.bl.ethos.570372

The actions of governments are instrumental in economic development, and an important lever of policy is fiscal policy. Taxation and spending cannot only promote economic development but inhibit progress and retard the process, and nowhere is this most evident than in sub-Saharan Africa (SSA), which is the focus of this study. Promoting economic development therefore requires that policies that inhibit the process are identified and addressed. In this light, this thesis investigates two common features of fiscal policy in developing countries that may slow down economic development: the first is that government consumption is pro-cyclical even though increasing (reducing) spending in response to increases (decreases) in income worsens income fluctuations. The second feature is that the budget deficit (budget balance) increases (decreases) in response to aid inflows. We address the issue of pro-cyclical government consumption in two stages: in the first stage a coefficient of cyclicality of government consumption is obtained for each of the sample countries using an improved (equilibrium-correction) specification. Variation in these coefficients across countries is then explained within a cross-section specification in the second stage. We conclude that credit constraint and political distortion are significant determinants of pro-cyclical government consumption. However, they are not the underlying reason why pro-cyclicality of government consumption increases with income uncertainty as existing explanation has it. Rather, the latter is the result of actions taken by the government to remain solvent in economic downturns. We investigate the aid-budget deficit relationship in three parts: the first part re-visits the past evidence, using more recent data, improved methods and a sample consisting of only SSA countries. We find that, consistent with past evidence, countries with larger budget deficits receive more aid and aid induces larger deficits. However, the effect of aid on the budget deficit has improved in recent times. This suggests that, contrary to existing explanation, giving more aid to countries with larger budget deficits is not the reason why aid induces larger deficits. Rather, we show in the second part that there is a divergence in the cross-section and within-country (year-to-year) dimensions of aid determination and the effect of aid depends on the latter: aid induces smaller deficits in countries where decreases in the budget deficit are associated with increased inflows of aid over time. Finally, we use a new approach to vector equilibrium-correction models (VECMs) to investigate the relationship between aid inflows and the fiscal aggregates that underlie the contrasting aid-budget deficit relationship across countries; we use Ghana (where the relationship is negative) and Zambia (where it is positive) as case studies. We conclude that aid induces lower deficits when year-to-year disbursements are conditioned on decreases in total expenditure and domestic borrowing. Even though aid inflows attracted by increased expenditure may still induce lower deficits, the magnitude of the decrease in expenditure is over-whelmed by the initial increase that attracted aid in the first place. We therefore conclude that to induce substantial deficit reductions, aid should be conditioned on decreased expenditure and domestic borrowing, or better still on reduced deficits. Thus, budget conditions are effective when enforced.