Foreign Aid and the Public Sector: A Model of Fiscal Behaviour in Pakistan

Zafar Iqbal


The main aim of this paper is to demonstrate the impact of
foreign capital inflows on government’s fiscal behaviour in Pakistan.
Government’s fiscal response is measured in terms of social,
non-development, and development expenditures as well as revenues. This
paper specifies and estimates a fiscal behaviour model for the period
1976–95. The threestage least squares results suggest that foreign
capital flows into the public sector have strong positive impact on
social and non-development expenditures and, in contrast to what the
government and donor agencies believe, have little effect on development
spending. In other words, proceeds from foreign loans and aid are
largely consumed rather than invested productively. The results also
reveal the strong substitutable interdependence between social and
non-development expenditures. Furthermore, the finding clearly
demonstrates that foreign assistance causes a strong shift of public
domestic resources from development projects to non-development
activities. In addition to the above, the results show that a large
fraction of government revenues is used to finance social and
non-development expenditures. The results also demonstrate that foreign
assistance enhances taxation efforts of the Government of

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