Twinobusingye

CHAPTER ONE INTRODUCTION 1.1 Background to the study Foreign aid represents an important source of finance in most developing countries. It is estimated that foreign aid accounts for about 10 percent of the GDP and 40 70 percent of the governments annual expenditure budget in Sub-Saharan Africa (SSA). It is estimated that over 90 percent of foreign aid projects in Sub-Saharan Africa (SSA) are implemented by foreign consulting firms. Critics of argue that foreign aid substitutes domestic resources through declined savings, reduced government tax revenue and increased government consumption. Aid reduces fiscal deficit in these countries and sets free other resources which can be utilized for debt service and other expenditures. There is need to analyze the effects of aid on the budget process by establishing the link between foreign aid and public expenditure. In spite of this massive foreign aid, developing countries are still poor today. In fact, no amount of foreign aid to a developing country like Uganda will solve its development predicament without addressing the core fiscal constraints facing the country, which are more often a result of misdirected or extravagant public expenditure projects, weaknesses in tax administration and corruption. The amount of annual public revenue lost through these loopholes is probably three to five times the foreign aid inflows. Uganda is a country hailed by international donors, especially the World Bank and the International Monetary Fund, as an African economic success story. The country depends on foreign aid for nearly 50 percent of her budget which has now been reduced to nearly 33 percent in the current financial year .Foreign aid is important in Uganda because it finances free primary education, free basic health care, and infrastructure rehabilitation and maintenance. However, is it true that without foreign aid Uganda would lack revenue to meet those public expenditure needs? Uganda has had a large proportion of government-to-government aid channeled through the budget in more recent years, but even so, this is still less than 50% of all aid to Uganda. And in

1

Twinobusingye

that regard, there are just as important questions about programme and project aid as there are about aid flowing through a government's budget - mostly around issues of sustainability, of fragmentation, of creating "islands of excellence" without addressing the deep-rooted systemic issues. As to aid which is delivered through government systems, the close attention to the integrity of that funding, ensuring that it reaches the poorest, and that it delivers real and tangible results, is uppermost in our minds. Far from being an "easy way to get rid of aid", supporting the budget is a complex, resource-intensive and closely monitored process. Studies on the effects of foreign aid on savings and growth in developing countries, besides having made a good case for increased flow of foreign aid, raise questions on the utilization of these funds on their designated projects (White 1992). The donor community has become increasingly concerned that part of the development assistance intended for crucial projects finances projects other than those earmarked for funding. For example a study by Uganda Debt Relief Network (2000) revealed that only 35% of the external funds reaches the designated targets, under scoring the notion that aid to developing countries is fungible. This may imply that aid recipient governments view foreign aid like any other source of revenue and consequently use it for increased consumption, tax reductions or reduced fiscal deficits (future tax obligations). An interesting question would be what proportion of increased spending resulting from increased donor funds goes to either recurrent or development expenditures. The answer can shed some light on the implications of an aid freeze to recipient countries, and highlight how governments in developing countries respond to fiscal deficits. Many promoters of foreign aid argue that the problem is not aid itself but how the aid is used. It is important to examine the logic behind aid, however. More money may not be the best solution to poverty for the simple reason that capital is a byproduct of the development process, not its prerequisite. True, even when politicians and bureaucrats steal much of it, aid can occasionally help. Part of it is sometimes used to build a school here, feed a hungry village there, or deliver medicines to a village full of diseased peasants. It is important to note that such aid can achieve only short-term humanitarian objectives. In the long term, aid can stifle domestic reform and, consequently, undermine the basis for long-term economic growth and prosperity.2

Twinobusingye

This study therefore seeks to find out the effects that foreign aid has had on public expenditure in Uganda, covering the period 1994/5 2008/9. Econometric analysis techniques will be employed. 1.2 Statement of the problem The government of Uganda has relied heavily on external assistance to finance its expenditures, both recurrent and development. In the financial year 1997/98, Uganda was classified as a highly indebted poor country and received debt relief in order to ensure that the Net Present Value of Ugandas debt to its exports remained at 150 percent. The debt was as a result of the countrys loss of initiative in controlling the flow and purpose of foreign aid. The channeling of foreign aid into productive versus non productive forms of public investment may have important policy implications. Even when foreign aid is given for strictly productive purposes, the principle of fiscal substitution tells us that some will go for non productive purposes; the extent to which this sort of fiscal substitution takes place will determine the effectiveness of aid. For the case of Uganda, the government has no direct control over budget financing any interruption to this flow can be very disruptive to the broader economy; therefore the study intends to analyze the growth of budget support during this period and its implications for the economy. 1.3 Purpose of the study 1.3.1 Main objective To find out the effect of foreign aid on public expenditure in Uganda for the period 1994/5 2008/9 1.3.2 Specific objectives 1. To find out the effect of budget support foreign aid on government expenditure for the period 1994/5 - 2008/9 2. To find out the effect of project support foreign aid on government expenditure for the period 1994/5 2008/9

3

Twinobusingye

3. To establish the long run relationship between foreign aid and government expenditure in Uganda 1.4 Research hypotheses

Government expenditure is not increasing with increase in budget support. Project aid is not increasing over the years.

1.5 Significance of the study Foreign aid has contributed to public expenditure in the view of its use in building schools, building hospitals, roads, etc. The paper highlights the fact that the government prefers budget support over project aid since statistics show that over the years more of budget support is incorporated in government expenditure than project aid. The findings of this work brings forth ideas, which can act as a benchmark against which a regulatory frame work can be can be designed in order to ensure that aid is properly channeled to areas of concern. The issue of aid fungibility is of great concern today as much

4

Twinobusingye

CHAPTER TWO LITERATURE REVIEW 2.1 Introduction Aid has traditionally been seen as something temporary, something that can only complement existing resources and efforts. It has become, in developing countries a considerable force in the national economy; making those countries more or less completely dependent on it. There has been a much stronger emphasis on market forces, rather than state-led growth. This study will focus on aid in form of project aid and budget support. Project aid is aid provided by donors through the financing of specific projects and budget support is where donors provide support to the recipient governments budget. The effectiveness of budget support is limited by the donors ability to monitor the actual final destination of budget expenses. The question is what does aid ultimately finances or what form of public expenditure is supported by donor funds? This is very important because some public spending have direct link with some macroeconomic variables like productivity and growth than others. The debate on aid effectiveness has focused on evaluating the impact of aid on growth. Fiscal analysts, including the donor community, are convinced that the aid process is undermined by the ability of the recipient governments to alter their spending patterns to subvert the sectoral distribution of expenditure for designated projects. Empirical literature on the impact of foreign aid and government expenditure is also inconclusive. A few studies (Heller, 1975; Khilji and Zampelli, 1991, 1994; Pack and Pack, 1993) have supported the theoretical proposition that developing countries have been rendering foreign aid fungible by transferring resources from the donor-aided sectors to non-donor aided sectors. Donor supported projects undermine development notably through imperfect competition in the procurement of consultancy services and lack of confidence on the part of the donors and recipient governments in the ability of domestic consultants to deliver these services at an acceptable standard of quality. Uganda is a higly aid dependent country, with aid averaging over 10% of GDP and half of public expenditures. The majority of aid is provided as grants, although loans make up approximately5

Twinobusingye

40% of on-budget aid. Uganda has had one of the highest sustained flows of budget support of any developing country. However, projects are still a major source of funding, and appear to be on the increase, whilst budget support appears to have stabilised in recent years. The aid environment is highly congested with over 40 donors operating in Uganda. The World Bank has historically been the largest donor in Uganda, with the EC being the second multilateral. The largest bilateral donor is the United States, followed by the UK. Other like-minded donors, made up of the Nordic countries, the Netherlands, and Ireland are the other major donors. 2.2 Effect of project aid on public expenditure Project aid and the project expenditures it funds usually involve different modalities. In most cases project aid does not flow through the Central Bank: instead it is either disbursed through accounts in local commercial banks or payments are made directly to foreign suppliers by the aid agency. If project aid does not flow through the central Bank, the expenditures funded from this aid will not create base money, although they will have an impact on aggregate demand. In Uganda, donor projects frequently comprise low priority expenditures that are not explicit objectives of the PEAP and have much higher unit costs than general government budget expenditure, including budget support. The counterpart funding and recurrent cost implications of such projects have to be met through the government budget and often crowd out essential spending in priority areas. A prime example is the roads sector where an imbalance between capital projects and operational expenditures has led to severe under funding of essential road maintenance. Since 1997/98, Ugandas fiscal deficit, excluding grants, has risen substantially by increasing expenditure (financed by donor aid) more rapidly than the growth in domestic revenues. 2.3 Effect of budget support on public expenditureBudget support has been used to endorse the Governments development strategy, improve the resource predictability and assert greater national control over the budget. Further, budget support has helped to reduce transaction costs and improve the coordination and harmonization of donor policies. Budget support

has had a major effect in increasing total and pro-poor expenditures. The latter have been largely6

Twinobusingye

channeled to basic services delivered by local governments. Ugandas public revenues and expenditures have increased. Budget support contributed 31% of the real increase in public expenditures between 1997/98 and 2003/04, when pro-poor expenditures increased from 17% to 37% of the budget with a knock-on effect in increasing the transfers to local governments. Budget support has been effective in increasing the discretionary funding on-budget, even when a substantial proportion has been notionally earmarked under the Poverty Action Fund, as the government was able to influence where that funding was earmarked to. Flows have been broadly predictable, inasmuch as the government has been able to expect continued high levels of aid, but there have been problems with short-term predictability of disbursements (which has recently improved). MFPED has coped with short-term unpredictability by discounting projected disbursements and using reserves to buffer expenditures. Budget support has contributed to allocative efficiency through the shift to pro-poor expenditures under the Poverty Action Fund (PAF), but the definition of pro-poor expenditures in the PAF is limited and programmes only get added but not withdrawn, which may limit the efficiency gain. Budget support has also increased operational efficiency, as an increased share of sector budgets is being channelled to service providers and there has been a relative decline in public administration expenditure; however, rapid increases in public expenditure may have weakened incentives to improve efficiency. There is also evidence that transaction costs for administering Budget support are relatively lower than for project support. It could be appreciated, however, that some donors prefer to earmark their support to sectors they are most interested in. In this case, sector support is only directed towards priority sectors with relatively large funding gaps and absorptive capacity. Conditions for success of Budget Support Two conditions must be met if donors are to focus on budget support as the main vehicle for providing aid: First, donors must share the recipient Government's broad priorities in terms of budgetary resource allocation and believe in the credibility of Government's economic policies.7

Twinobusingye

Second, donors must be confident that the recipient Government has the administrative capacity and adequate rules and procedures to ensure that Government funds are spent effectively and efficiently, and for the purposes specified in the budget. For this reason, building institutional capacity in the recipient countries to plan, implement and monitor expenditure programmes, and to maintain budget discipline and accountability remain essential for strengthening ownership of aid programmes. Firmer Indications from Donors of Medium Term Support To improve the effectiveness of the Medium Term Expenditure Framework as a tool of medium term budget planning, Governments need more information from donors as to how much budget support donors will provide over a three-year period. In Uganda, the MTEF has gone a long way to improve transparency on the part of Government as to how it intends to use budgetary resources. The donors should match Governments effort with greater transparency of their own about the level of funding they intend to provide. Clearly it is not feasible for donors to give unconditional medium term commitments, but they can at least provide the recipient with projections and make explicit the assumptions on which their projections are based. Government - Donor Coordination In Uganda, the area where probably the greatest progress has been made in improving coordination between Government and donors, and among donors themselves, is in the Sector Wide Approaches (SWaPs). Donors have set up formal sub-groups for co-ordination covering a number of sectors, such as Health, Education, Water, Justice Law &Order, and Agriculture, which meet regularly. These sector sub-groups assist the relevant Government Ministries to prepare their sector strategies and investment plans. Budget Monitoring In terms of monitoring budget implementation, the World Bank supported PRSC program provides a major vehicle for encouraging donors to support Governments efforts to strengthen all aspects of fiscal management and thus improve the quality of service delivery in support of the PEAP. Under the PRSC, Government has committed itself to strengthening the budgeting and MTEF processes and improving the efficiency with which it provides services. Donors supporting the PRSC are able to hold Government accountable for the effective use of funds8

Twinobusingye

through both the PRSC steering committee, to which all interested donors are represented, and the sector reviews. There are prior conditions that have to be agreed on with Government to be met each year in order to qualify for the next PRSC. Government then has every incentive to meet these pre conditions; a failure to meet them would endanger funding not only from the World Bank, but also from bilaterals. Fiscal Deficits and Donor Funding for the Budget Because Uganda has a good record of economic management and has established sectoral budgetary priorities which donors support, many donors are willing to provide the country with larger volumes of aid, provided that the aid is allocated, in an accountable manner, to poverty focused programmes. However, there is a potential conflict between the objectives of Government, to fund higher levels of spending on poverty-focussed programmes, and the objective of medium term fiscal deficit reduction. The GOU is concerned that fiscal deficits may not be sustainable, because future aid flows are uncertain but also because of the macroeconomic implications of the fiscal deficit and its attendant implications for the exchange rates and the interest rates. Aid Freeze The disbursement of most foreign aid funds has been short-lived as the donors often find themselves dissatisfied with the way the government implements aid conditionalities

9

Twinobusingye

CHAPTER THREE METHODOLOGY 3.1 Introduction This chapter presents the various techniques that will be used during the study in collecting and analyzing data in order to answer research questions. We present a simple model for analyzing how a government responds to aid flow in the process of executing its budgetary plans. This approach follows Hellers (1975) utility model, which is used to determine the impact of foreign aid on government expenditure and tax revenue. 3.2 Data type and source Data used in the study will mainly be secondary obtained from the annual budget reports, statistical abstracts, UBOS, BOU reports, particularly data on budget support, project support and total government expenditure will be collected covering the period 1994/5 - 2009/10. 3.3 Data processing and analysis After collection, data will be entered in excel and exported to E-views 3.1 for further analysis. 3.3.1 Diagnostic procedure Test for normality A reasonable and more practical approach to estimation when the normality of disturbance is in doubt is to compute Least square estimates and minimising the sum of absolute deviations of the regression coefficients. If the two estimates are not far apart, we may have no cause for concern. A more formal way of checking for a departure from normality involves a proper statistical testing procedure. Several procedures for testing the hypothesis that a set of random sample observations comes from a normal population are available in literature.

10

Twinobusingye

In this particular case, normality is tested for by use of the Jarque Bera method. This tests for the values of the moments corresponding to the shape of the distribution in question. Other tests for normality include kurtosis and skewness. Test for stationarity This is by using the Augmented-Dick-Fuller test which tests whether a unit root is present in an autoregressive model. In case the data is not stationary, Test for multi-collinearity It is of essence that none of the explanatory variables be perfectly correlated with any other explanatory variable or with any linear combination of other explanatory variables. Multicollinearity 3.3.2 Theoretical model The model is represented in the form of an exponential equation as shown below G = f (Budget support, Project aid, Domestic revenue) Gt = 0 + 1 BSt + 2 PAt + 3 DRt + t..(1) Where Gt represents total government spending on public expenditure due to budget support (BS), project aid (PA) and domestic revenue (DR). The s are the respective coefficients Using ordinary least squqres, equation (1) is transformed as below ln Gt = n0 + 1 ln BS + 2 ln PA + 3 ln DR + t.(2)

11

Twinobusingye

CHAPTER FOUR PRESENTATION, ANALYSIS AND INTERPRETATION OF FINDINGS4.1 Introduction. This chapter presents findings of the study and their interpretations in accordance with the specified objectives. The study is based on information obtained from the statistical abstract accessed from the university library. 4.2 Summary of Foreign aid for the period 1994/5-2009/10. Table 4.1; Summary of budgetary contribution of Budget Support and Project Support (billion Shillings)

Financial Year 1994/5 1995/6 1996/7 1997/8 1998/9 1999/2000 2000/2001 2001/2002 2002/2003 2003/2004 2004/2005 2005/2006 2006/2007 2007/2008 2008/2009 2009/2010

Budget Support Project Aid

Domestic Revenue

Expenditure

393.9 366.2 801 823.6 484.36 733.22 475.23 530.85 631.93

363.1 453.6 465.9 431.6 413.15 354.57 263.25 353.95 292.67

1253.6 1434 1669.2 1914.6 83 96.68 85.73 124.29 82.21

2567.9 2770 3136.1 3277.5 3019.86 3487.69 3759.83 4173.62 5208.02

Source: Ministry of Finance, Planning and Economic Development From the table, results show that budget support12

Twinobusingye

The Results The results assess h

REFERENCES Andrew Mwenda takes a new look at Africa TED Global 2007 www.ted.com/.../andrew_mwenda_takes _a_new_look_at_africa.htlm All Africa.com: Uganda. It is Easy to measure Foreign Aid Results allafrica.com/stories/200907300271.htlm C. Adam. (2005). Aid, Public Expenditure and Dutch Disease Ideas.repec.org/p/wpa/www.pdc/0409027.htlm Devarajan S. A.S. Rajkumar and V. Swaroop. 1998. What does aid to Africa finance?13

Twinobusingye

AERC/ODC project on Managing a Smooth Transition from Aid Dependence in Africa, Washington, D.C. ESCAPA Newsletter vol.9 no.15 Ian, Clarke. New Vision 29 July 2009, article on gains from aid. Mwenda. A. (2006). Foreign Aid and the weakening of Democratic Accountability in Uganda www.cato.org/pubs/fpbriefs/fpb88.pdf Njeru, James. 2004. The impact of foreign aid on public expenditure: The case of Kenya. African Economic Research Consortium, Research paper no. 135 (March) Tabi A. Johannes. (2006) Foreign Aid and the Public Sector Budget Process in a Developing Country: The case of Cameroon. Paper presented at the First International Conference on the State of Affairs. Tabi Atemnkeng. J., Akwi T. and Etoh-Anzah, A. P.2006. The distributive impact of fiscal policy in Cameroon: tax and benefit incidence. Poverty and Economic Research NetworkPMMA working paper no.16, Universite Laval, Canada. White, H. 1994. The Macroeconomic impact of Development aid: A critical survey. Journal of Development Studies, 21(2).163-240.

APPENDIX

14