This paper examines whether the degree of fiscal decentralization in aid-receiving countries matters in explaining aid effectiveness. The decentralization theorem predicts that the devolution of powers should increase aid effectiveness, since local decision-makers are better informed about local needs. Thereby decentralization may also have reverse effects, e.g., through coordination problems, excessive regulation, administrative costs, and local capture. We use panel data for up to 60 countries and find that aid contributes to economic growth in centralized developing economies. Whereas it is less effective or even harmful in decentralized countries. The cases of Indonesia, the Philippines, and Uganda support our findings. Our results imply that donor countries should carefully consider how the two development instruments—foreign aid and decentralization—interact.
