Development aid and its impact on poverty reduction in developing countries

Purpose: This paper aims to assess whether official development assistance (ODA) or foreign aid has been effective in reducing extreme poverty; test whether the type and source of aid matter; and examine whether political or economic freedom enhances aid effectiveness in developing countries. Design/methodology/approach: The study uses recent dynamic panel estimation techniques (system generalised method of moments), including those methods which deal with endogeneity by controlling for simultaneity and unobserved heterogeneity. Findings: The main findings of the study are: firstly, foreign aid does have a statistically significant poverty reduction effect and the results are consistent across all the three extreme poverty proxies. Secondly, the disaggregation of aid by source and type shows that total aid, grant and bilateral aid are more likely to reduce poverty. Thirdly, political freedom might not be an effective channel through which aid impacts extreme poverty, but aid is more effective in an environment where there is respect for freedom of enterprise. Research limitations/implications: As with most cross-country aid–growth–poverty dynamic panel data studies, the challenges of establishing robust causality and accounting for the unobserved country-specific heterogeneity remain apparent. However, given the data availability constraints, generalised method of moments is, to the best of the authors’ knowledge, the most robust empirical strategy when T < N. Future research could explore possibilities of individual country analysis, disaggregating countries by income and also examining the direction of causality between foreign aid, poverty and democracy. Practical implications: The policy implications are that the development partners should continue to focus on poverty reduction as the main objective for ODA; aid allocation should be focused on channels which have more poverty-reduction effect, such as per capita income and economic freedom; and aid recipient countries should also focus on reducing inequality. Social implications: The main social implications from this study is that it is possible to reduce poverty through ODA. Second, to enhance the effectiveness of foreign aid, ODA allocation should be focussed on channels, which have more poverty-reduction effect, and the host countries should have economic freedom. Originality/value: This paper makes a further contribution to the aid effectiveness literature, especially the channels through which foreign aid affects poverty.