Foreign Aid, Corruption, and the Informal Economy in Weak States

We develop a general equilibrium model, that builds on Acemoglu and Verdier (American Economic Review, 2000), to study the relationship between foreign-aid, corruption, and the size of the informal economy in weak states. In this model citizens endogenously choose to enter the formal economy (which generates a positive externality), the informal economy, or may become bureaucrats who regulate and impose fines on the informal economy. Bureaucrats are corruptible: they may accept a bribe in exchange for not fining citizens in the informal sector, or may extort payments from citizens in the formal sector. The government endogenously raises revenues through taxes and fines that either finances public goods or may be used for the government's personal gain. Following Ferrara and Bates (Economics and Politics, 2001), the government or state is weak in the sense that: (1) it does not have monopoly over coercion, and (2) it can extract rents from public revenues. The model is intended to reflect states like Somalia where citizens choose between formal economic activities (farming), informal activities (e.g. piracy), or may work for the state (bureaucrats).

In our benchmark model we find that if the positive externality from the formal economy is not too large or small, then in equilibrium there is both a formal and informal sector. In this case, as long as the state is not too weak, the government raises revenues through fines received from the informal sector and taxation. However, if the state is sufficiently weak, then the government raises revenues only through the fines received from informal sector. We extend this benchmark model to study the impact of: (1) an unconditional aid transfer program and (2) a targeted aid program where foreign aid is targeted to subsidize the formal sector, or is targeted to fight corruption.

This extended model offers several insights into the relationship between foreign aid and corruption. First, we find that in an unconditional aid program the government does not transfer any aid to its citizens and aid does not affect the size of the informal economy. Thus, our result finds support for the argument that in weak states, unconditional aid programs merely “line the pockets” of the government. Second, we find that in a targeted aid program if the positive externality from the formal economy is sufficiently small, an increase in aid reduces the size of the bureaucracy, but increases the size of the informal economy at the expense of the formal economy. Third, if the positive externality is large then an increase in targeted aid has an ambiguous affect on the size of the formal economy. Thus, in weak states even targeted aid programs may not have the desired effect on the size of the formal economy.

We extend the above results to the model with corruptible bureaucrats and examine the government’s incentives to fight corruption and reduce the size of the informal sector under various aid programs. Finally, we examine the effectiveness and the impact of targeting aid directly towards policies that fight corruption.