Tied Aid and the Paradoxes of Donor-Enrichment and Recipient-Impoverishment

It is part of received doctrine that, in a two-country world without hindrance of commodity taxes or other distortions and with market stability assured, international transfers necessarily harm donor and benefit recipient.2 However, in case of most non-private international aid, those conditions fail. Donors often require that aid be spent in a manner not closely related to private preferences in recipient countries, indeed not closely related to any well-behaved preferences and they normally finance aid by means of distorting taxation. Hence, one cannot rule out by appeal to standard theorems possibility that aid perversely leaves donor better off and/or recipient worse off. Let us say that aid is tied in recipient if it is spent inefficiently in terms of individual preferences and that aid is tied in donor if it is financed inefficiently. Thus, whether aid is tied is a question of how it is spent (or financed). It is not a question of numeraire in terms of which aid is accounted nor of form in which it is offered.3 Evidently definition of tying is uncommonly broad. For example, aid may be tied in recipient not because donor attaches strings but because government of recipient is incompetent or unrepresentative. Moreover, definition is relevant however aid is applied whether to private or public goods, whether to consumption or investment goods. We follow literature on the transfer problem in assuming that aid is spent on private consumption goods, like hospital services and powdered milk. This is a matter of convenience and continuity only.4 In present note, we seek to rework economics of foreign aid under novel assumptions. In particular, allowance will be made for possibility that aid is tied, in whole or in part, in donor or in recipient. It will be verified that donor may benefit and recipient suffer and that these outcomes are com-