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Paper short abstract

We examine how development aid influences public expenditure choices at the subnational level in India during the 1978-2019 period. Using an excludable instrument, we find that development aid is associated with a diversion of government spending on capital expenditure to revenue expenditure.

Paper long abstract

The question of whether aid supplements or substitutes domestic spending has long been debated in public finance literature. Using a panel covering 30 Indian states during the 1978-2019 period (42 years), we examine how development aid influences public expenditure choices at the subnational level. To address potential endogeneity, we employ an excludable instrumental variable strategy. Our results reveal that development aid is associated with a decline in capital expenditure while simultaneously increasing revenue expenditure. This pattern indicates a substitution effect rather than complementary. The state governments may interpret aid inflows as a replacement rather than a supplement to their own development spending. In practical terms, capital expenditure that might have been allocated to long-term infrastructure, public works, or other capital-intensive projects appear instead to be diverted toward recurrent expenditures.

Furthermore, we also examine the role of political incentives. Using an interaction model, we find that the positive effect of development aid on capital expenditure is conditional upon electoral competition. Specifically, in states characterized by more competitive electoral environment, governments are more likely to channel aid into visible capital projects, consistent with theories linking political competition to public goods provision. Overall, the findings demonstrate that aid can lead to a diversion of government capital expenditure to revenue expenditure. This shift can have long-term implications for economic growth, sustainability, and social equality. However, its effectiveness is also shaped by political context, with electoral incentives mediating whether aid supports sustainable capital investment.