Journal Article

2015-05-28

Oxford Economic Papers

University of Cape Town

Despite official discourses of donors, the most corrupt countries receive the highest amounts of foreign aid. The most corrupt countries are however also the poorest, and this is why they may receive more aid. This paper provides the first theoretical and empirical grounds for this rationale. The key is that corruption is not exogenous but, instead, an equilibrium phenomenon. We build a multi-country model of optimal aid in which we disentangle the correlation between aid and corruption into two components: the first reflects variations in the quality of institutions and the second variations in productivity levels. The data suggest that both components of the correlation are significant; however the effect of variations in productivity levels is stronger. Because the cross-country heterogeneity in productivity is more important than the heterogeneity in institutional quality, it is optimal to give more foreign aid to more corrupt countries.