Essays on the Impact of Aid and Institutions on Income Inequality and Human Welfare

Billions of dollars in development aid are sent to developing countries every year. Weak institutions in recipient countries are the main impediments often discussed to prevent aid from reaching the intended targets. At the same time, they also hinder aid effectiveness in improving the lives of the people. This dissertation argues that the impact of aid on income distribution and human welfare in recipient countries differs by their institutional quality. Institutions encompass many different dimensions. This dissertation focuses on: corruption in government, quality of bureaucracy, and the rule of law. This study explores the impact in two essays. The first essay investigates the role of institutions in aid distribution. In particular, we examine the interplay between aid and institutions on income shares of different population groups (measured by income quintiles), and on the gap between the rich and the poor (measured by the Gini coefficient). The study uses Principal Component Analysis to construct an institutional index from the three components: corruption, bureaucratic quality, and the rule of law. Employing Two-Stage Least Squares (2SLS) methodology on a panel data of 85 countries from 1960 to 2004, this study finds that an increase in aid as a percentage of Gross Domestic Product (GDP) decreases the income shares of the poor (quintile 1 and quintile 2), but increases that of the rich (quintile 5), thereby widening the gap between the rich and the poor (Gini coefficient). Contrary to our main hypothesis, though, recipient countries’ institutions do not play any role in aid distribution. Similarly, the second essay also focuses on the importance of recipient institutions, but it assesses aid effectiveness in improving human welfare. The study considers five human development indicators: the Human Development Index (HDI), the health index, the infant mortality rate, the education index, and the average years of schooling. The study empirically tests the hypothesis by utilizing the same methodology as in the first essay, but on a panel of 80 countries from 1980 to 2004. The findings suggest that human welfare in recipient countries improves as aid increases. The improvement appears to be driven more by the health than the education sector. Furthermore, aid is more effective in countries with poorer institutional quality, which is contrary to the hypothesis. However, the results are not consistent when taking into account government’s pro-poor public expenditure