Expenditure and Revenue Implications of Increases in Aid Inflows: The Case of Uganda Implications of Increases in Aid Inflows on Government Expenditure and Tax: Estimation of a Vector Error Correction Model

By Max Ochai
2015
This study aims at examining the impact of aid inflows on Government expenditure and tax effort with a view to generating evidence-based information to guide policy-decisions in Governments of the Macroeconomic and Financial Management Institute of Eastern and Southern Africa member countries. Using the Ugandan data, it estimates a Vector Error Correction model to analyse the long-run equilibrium relationships between Government expenditure, tax and foreign aid and to examine their short-run dynamics, as well.
The results from the long-run equilibrium analysis show that aid inflows positively impact on the economy. It is evident that a 1% increase in real aid is likely to lead to an increase in real tax by approximately 1.7% and Government real expenditure by about 2.3% per annum, at 5% level of statistical significance. There is also evidence of aid Granger causing a rise in Government expenditure and tax revenue. The short-run dynamic analysis finds that Government spending adjusts faster, at a speed of -0.7 per period, than tax, at -0.2, to the long-run equilibrium path. This implies that the long-run equilibrium conditions influence the short-run adjustments in the economy.
The study concludes that aid inflows matter in Uganda: the resource envelop is able to expand with a surge in aid inflows. Since aid is a finite resource, formulation of an exit strategy from aid dependency syndrome is desirable. To that end, it is recommended that Uganda should continue receiving aid and increasingly allocate the proceeds to strategic priority areas in order to stimulate economic activities that will, ultimately, generate tax revenue, which is a more dependable resource than aid.