Effect of foreign aid on revenue mobilization: case of Rwanda

Abstract

Foreign aid effect on domestic resource mobilization is a very controversial debate among researchers. While some studies support that foreign aid is beneficial to the recipient country, others argue that it may simply have a substitute effect or a crowding out effect. When aid is disbursed, the government invest the received funds in sectors that will create a potential for prospective tax collections. Instead of being substituted to tax collection efforts, aid receipts do complement government effort to finance its development program. Empirical studies have shown that a positive relationship between aid and tax occurs in countries where institutions are strong, sound macroeconomic policies, or low corruption levels. On the other hand, the lack of strong institutions, high levels of corruption, or weak macroeconomic management may represent a challenge for country's domestic revenues mobilization strategy. Contrary to other studies, this research concludes that in the case of Rwanda there is a positive effect. As ODA flows increase, tax is affected by 0.6 percent, this is explained by Rwanda’s institutional strength and efforts invested in tax administration. I use the twostep Engel Granger procedure, because variables are found to be non-stationary in the short run while they present a long term relationship.