Rev World Econ (2014) 150:619–638

DOI 10.1007/s10290-014-0187-4

ORIGINAL PAPER

Identifying thresholds in aid effectiveness

Laurent Wagner

Published online: 12 February 2014

Ó Kiel Institute 2014

Abstract In this paper, the author focuses on the nonlinear nature of the aid to
growth relationship to show that the ‘‘Big Push’’ hypothesis is consistent with
capacity constraints in the understanding of aid effectiveness. The Big Push
hypothesis proposes the existence of one threshold below which aid is not effective,
whereas the constraints inferred by the concept of absorptive capacity suggest the
existence of a second threshold above which aid is no longer effective. This paper
addresses the issue of these thresholds which characterize the aid to growth rela-
tionship. Using a semi-parametric econometric method, the author finds that aid
becomes effective only above a critical level, but what is more it becomes detri-
mental to growth at high aid flows. The author also investigates how the quality of
institutions and economic vulnerability modify the level of these two thresholds. He
finds that economic vulnerability is a key factor conditioning aid effectiveness.

Keywords Economic growth  Aid effectiveness  Threshold models  Semi-

parametric regressions

JEL Classification F35  C14  040

L. Wagner (&)
Centre d’Études et de Recherches sur le Développement International (CERDI), École d’Économie,
Université d’Auvergne (Clermont-Ferrand 1), 65 Bd. F. Mitterrand, 63000 Clermont-Ferrand,
France
e-mail: laurentwagner@ymail.com

L. Wagner
Fondation pour les études et recherches sur le développment international (FERDI),
Clermont-Ferrand, France

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1 Introduction

Since the seminal work of Burnside and Dollar (2000), the question of the
conditions on which aid effectiveness depends has become central in the aid debate.
Basically, Burnside and Dollar found that aid is effective only if the quality of the
recipient country’s economic policy is good enough. Consequently, in order to
maximize aid efficiency, donors have to condition their disbursements following the
recipient country’s policy and institution ratings (Collier and Dollar 2002). Today
this recommendation is still widely followed by the World Bank as well as by some
national aid agencies, although serious doubts have been cast by many authors about
the robustness and relevance of its reasoning (see Rajan and Subramanian 2008;
Roodman 2007; Easterly et al. 2004; for examples of this critique). Besides
countries’ policies or institutions (or instead of them), Guillaumont and Chauvet
(2001), Chauvet and Guillaumont (2004), Collier and Dehn (2001), Collier and
Goderis (2009), and Guillaumont and Wagner (2012) argue that macroeconomic
vulnerability has to be accounted for to identify the effect of aid on growth, because
macroeconomic vulnerability is likely to increase the marginal impact of aid on
growth.
Following similar reasoning, a second branch of research has argued that an
important part of the story is ignored by not taking into account the absorptive
capacity of aid-receiving countries. This branch of research implies that the aid to
growth relationship may show diminishing returns (see Feeny and McGillivray 2011
for an extensive review). A large number of studies have examined this hypothesis
and have confirmed, to some extent, the existence of such a relationship between aid
and growth.1 These studies typically estimate a simple growth equation by
introducing aid over GDP and its squared value.2 The related coefficients’ signs are
found to be respectively positive and negative, implying an inverted-U shape
relation between aid and growth, whose upper limit gives the value of the threshold
for the maximum contribution of aid to growth. This point represents the maximum
level of aid a country can manage efficiently—also known as its absorptive
capacity. However, as mentioned in Guillaumont and Guillaumont Jeanneney
(2010) and Feeny and de Silva (2013), while it is widely agreed that the marginal
returns of aid decrease at the macroeconomic level, numerous and often
contradictory hypotheses have been formulated to explain the nature of the capacity
constraints—for instance capital, policy, institutional, macroeconomic, social, and
cultural constraints, and also donor practices.
Whereas diminishing returns imply an inverted U-shape relationship between aid
and growth, another part of the literature supports the alternative hypothesis that
only large aid inflows could initialize upward paths to economic development,
pointing to more complex nonlinearities. This particular view of aid effectiveness,
which refers to the ‘‘Big Push’’ concept, is based on the assumption that developing
1
See Hadjimichael et al. (1995), Durbarry et al. (1998), Lensink and White (2001), Dalgaard and Hansen
(2001), Hansen and Tarp (2000, 2001), Roodman 2007.
2
Combining diminishing returns and conditional effects of aid, Collier and Dollar (2001, 2002)
introduce the aid squared term besides the multiplicative ‘‘aid 9 policy’’ variable in an attempt to solve
the problem of an optimal aid allocation.

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countries are stuck in poverty traps, because they lack the minimum capital needed
for making productive investments and that aid can help by closing this financing
gap. Thus, the ‘‘Big Push’’ hypothesis refers to aid financed investments that would,
if large enough, lead to growth. This concept of ‘‘Big Push’’ implies that the
relationship between aid and growth is nonlinear and should display positive returns
only if the level of aid is above a minimal threshold. To our knowledge, very few
empirical studies provide support for this hypothesis, primarily because of the
difficulties to estimate such nonlinearities. For example, Gomanee et al. (2003),
after implementing a threshold regression, find a nonlinear impact of aid. They
argue that aid raises growth positively and significantly only if the official
development assistance (ODA) to GDP ratio is above 2 %. So in order to effectively
stimulate growth the amount of aid has to reach a critical level. Alternatively, if aid
flows are too low, aid is unlikely to foster economic development.
Thus, two opposing concepts—of capacity constraint and Big Push—dominate
the present aid debate. On one hand, there is the United Nations objective of
doubling aid to reduce poverty by half, and on the other hand, the scepticism that aid
will not be absorbed usefully. While apparently contradictory, these views of aid
effectiveness are not really new and paradoxically have common roots (Rosenstein-
Rodan 1943; Millikan and Rostow 1957; Chenery and Strout 1966). Both concepts
are founded on the idea that low-income countries face structural problems to
growth, which are reflected in their absorptive capacity and which require massive
investment in inter-dependent sectors—the so-called ‘‘Big Push’’—to be resolved.
The amount invested has to reach a critical amount to tackle key bottlenecks
simultaneously in order to initiate growth. Thus, the relationship between aid and
growth should be significant only if the amount of aid disbursed is above a certain
threshold. This requirement is behind the argument for doubling aid in order to fill
the financial gap but also to lift countries out of a stagnation trap which would be
impossible to escape otherwise (Sachs 2005). These arguments have been strongly
criticized notably in Easterly (2006) in an attack against the very idea of the
existence of traps and its Big Push corollary. Other critical opinions have pointed to
the capacity issue, and highlighted the fact that an unconsidered increase in aid
disbursement is likely to be partially wasted (Collier 2006). More recently, Feeny
and de Silva (2013), in line with Feeny and McGillivray (2011), show that it is
possible to estimate individual countries’ own capacity thresholds and that a
significant number of developing countries receive more aid than they can manage.
According to their estimates, doubling aid indiscriminately would provide
inefficient levels of aid to many countries. However, they show that the majority
of developing countries are far from receiving the amount of aid that maximizes
growth, and would benefit from a targeted increase in their aid allocation. Thus, they
argue that a large increase in foreign aid budgets would lead to a significant increase
in economic growth, if and only if, the issue of absorptive capacity is taken into
account by donors in their allocation frameworks.
Examining how to empirically reconcile ‘‘Big Push’’ and ‘‘absorptive capacity’’,
Guillaumont and Guillaumont Jeanneney (2010) suggest the existence of two
successive thresholds, a lower one corresponding to the aid level required for a ‘‘Big
Push’’, and an upper one corresponding to absorptive capacity. But they consider

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that these two thresholds cannot be properly estimated simply by introducing

squared and cubed aid terms in the standard growth equation (How to interpret the
negative marginal returns below the lower threshold? How to specify null rather
than negative returns?), and that it would be difficult to treat simultaneously the
possible conditional effects of aid.
In this paper we argue that the assumption of two thresholds is logical and that
multiple thresholds may characterize the aid to growth relationship as countries
overcome or encounter new constraints. Our objective here is to re-address the
nonlinearity issue by implementing an econometric strategy which allows us to
discover the way growth responds to aid in a more complex, but more
understandable, way than in the studies mentioned above. The semi-parametric
model that we use is a partially linear model that allows for the nonlinear
component to be entered additively. Whereas the traditional semi-parametric
partially linear regression treats the variables which are entered into the non-linear
part of the model as nuisance variables, the semi-parametric additive model allows
for the explicit estimation of the marginal effects of the nonlinear components on
the dependent variable. Furthermore, this estimation procedure offers graphical
representations which provide a useful way of visualizing the analysis. We find that
the aid to growth relationship is highly nonlinear, and that economic vulnerability is
a key factor in influencing the level of the aid to growth thresholds.
In the next section we present the basic econometric framework that we use to
analyse our data. In Sect. 3 we then proceed to discuss our empirical findings.
Lastly, in Sect. 4 we offer conclusions.

2 Methodological issues

The core hypothesis of the literature that studies the nonlinear effect of aid on
growth is that aid displays diminishing returns, and above a certain threshold,
becomes detrimental to growth for a particularly high aid to GDP ratio. So some
countries which receive aid flows above such a threshold should have their aid
reduced, as argued in Lensink and White (2001). However, as shown in Gomanee
et al. (2003), if there is a threshold where the aid to growth relationship reverses, the
simple inclusion of a squared term might not be effective in identifying these
thresholds. Nevertheless, the threshold regression has its own caveats. Because the
estimation process is sequential, the initial threshold values are never revised as the
number of splits rises. Hence, small changes in the data might have a significant
impact on the stability of the model.
Our objective is to propose an empirical strategy that might address these issues
with a common framework. Non-parametric regression relaxes the usual assumption
of linearity, and enables the researcher to explore the data more flexibly, uncovering
patterns in the data that might otherwise be missed.
Hastie and Tibshirani (1986, 1990) proposed additive models. These models
estimate an additive approximation to the multivariate regression function. The
benefits of an additive approximation are at least twofold. First, since each of the
individual additive terms is estimated using a univariate smoother, the ‘‘curse of

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dimensionality’’ (Bellman 1961) is avoided, at the expense of not being able to

approximate universally. Second, estimates of the individual terms explain how the
dependent variable changes with the corresponding independent variables. Such
methods usually combine features of parametric and non-parametric techniques. As
a consequence, they are usually referred to as semi-parametric methods. A further
advantage of the semi-parametric method is the possible inclusion of discrete as
well as continuous variables, and they can be included in a parametric way.
Additive semi-parametric models are also interesting from a statistical point of
view. They allow for an analysis by component, and combine flexible non-
parametric modelling of multidimensional inputs with the statistical precision
typical of a one-dimensional explanatory variable.
A generalized linear model (GLM) is a regression model of the form
EðYjXÞ ¼ GðX0 bÞ;
where Y is the dependent variable, in this case the rate of growth of GDP per capita,
X is a vector of explanatory variables, including the aid to GDP ratio as our variable
of interest, and other control variables usually used in the aid literature, with b an
unknown parameter vector and G(.) a known link function. The generalized additive
partial linear model (GAPLM) extends the GLM with a non-parametric component
and takes the form
EðYjX; AidÞ ¼ GfX 0 b þ f ðAidÞg;
where EðYjX; AidÞ denotes the expected value of the dependent variable Y given X.
Aid is the variable for which we want to explore nonlinearities, in this case the aid
to GDP ratio. The index X 0 b þ f ðAidÞ is linked to the dependent variable Y via a
known link function G(.). The parameter vector b and the function f(Aid) need to be
estimated. The flexibility and convenience of using a GLM formulation comes at the
cost of two theoretical problems. First it is necessary to determine how to smooth
this component and also to determine how smooth it has to be. We rely on
regression splines. We have to choose a basis, defining the space of functions on
which f is an element. Choosing a basis amounts to choosing some basis functions,
which will be treated as completely known: if tj(Aid) is the jth of such basis
function, then f is assumed to have a representation
X
q
f ðAid Þ ¼ tj ðAid Þhj ;
j¼1

for some values of the unknown parameters, hj. Combining these two equations
clearly yields a linear model. The second issue is about the level of smoothing. If the
objective is only to minimize the sum of the squared residual, this method will yield
an estimation of f not smoothed enough to detect clear breaks. It is then necessary to
set a penalty to the least squared objective for our estimation to become the best
tradeoff between smoothing and fitting the data. Rather than fitting the model by
minimizing,

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2
kY  X0 b  f ðAidÞk ;
it could be fitted by minimizing,
Z
2 2
kY  X 0 b  f ðAidÞk þk ½f 00 ðAidÞ dA;

where the integrated square of the second derivative penalizes models that are not
smoothed enough. The tradeoff between model fit and model smoothness is con-
trolled by the smoothing parameter, k. The fact is that k ? ? leads to a straight
line estimate for f, while k = 0 results in an un-penalized regression spline estimate.
In this study, this penalty parameter will be estimated by generalized cross vali-
dation, while other parameters are estimated using iteratively reweighted least
squares (P-IRLS).
This methodology allows us to estimate the nonlinear component of the aid to
growth relationship. The advantage of using this methodology is that we are not
making any assumptions regarding the nature of the marginal returns (by including
an aid-squared or aid-cubed term) and the number of thresholds. This provides us
with a straightforward graphical representation of the GDP growth response for the
whole range of the aid to GDP ratio. It also enables us to explore more easily some
aspects of aid effectiveness which are conditional on other variables, as it is also
possible to specify a function of multiple variables.

3 Data presentation

The empirical analysis is based on data for 89 developing countries and follows
previous empirical work by Rajan and Subramanian (2008).
We use pooled cross-country data averaged over 11 four-year periods from 1970
to 2009. We estimate a classical Barro-type growth equation with 4-year average
GDP per capita growth rate (GDPG) as our regressand. In order to make our result
more comparable with the previous literature, we first choose to stay relatively close
to the Rajan and Subramanian (2008) main specification, although we use an
extended sample and add controls. We include the initial level of GDP per capita
(LGDP). Both GDPG and LGDP are from Heston, Summers and Aten’s (2009)
Penn World Tables version 6.3. We include an index of structural economic
vulnerability, the Economic Vulnerability Index, also used at the UN for the
identification of LDCs and calculated at the Foundation for Ideas on Development
(FERDI) on a retrospective basis. It is a simple average of an index of the intensity
of exogenous shocks (Shock index), based on three components, and of the exposure
to these shocks (Exposure index), based on four components. In other words, it is a
weighted average of seven components (Instability of exports, Instability of
agricultural production, Homeless population due to natural disasters (for shocks),
and Low population size, Distance from world markets, Export concentration and
Share of agricultural value added to GDP (for exposure) (details on this index in
Guillaumont (2011), and Cariolle (2011)). We include the Human Assets Index
(HAI), a composite index of health and education, used at the UN for the

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Table 1 Summary statistics for

Percentiles
Net ODA disbursements over
GDP (data is averaged over 11
1% -0.01 % Observations = 532
four-year periods)
5% 0.01 % Countries = 89
10 % 0.04 %
25 % 0.26 % Mean = 2.91 %
Variance = 0.001
50 % 1.49 %
Largest values
75 % 4.64 % 13.08 %
90 % 7.67 % 14.65 %
95 % 10.01 % 15.99 %
99 % 12.63 % 16.05 %
Source: Author’s calculations

identification of LDCs and made available at FERDI on a retrospective basis for a

large number of countries. We include a variable from Marshall and Jagger’s (2013)
Polity IV database reflecting institutional quality PolityIV, and MEPV, a variable
which reflects the occurrence and severity of intra-state and inter-state conflict from
the Major Episodes of Political Violence and Conflict Regions database of the
Center for Systemic Peace. Lastly we include three variables reflecting economic
policies: Inflation rate, M2 over GDP, and Government spending over GDP, all
from The World Bank’s World Development Indicators.
The ODA data are taken from the DAC data base. Net disbursements are used,
bearing in mind that these data are debatable for the assessment of aid impact, but
more relevant data is not available for the period concerned.
Table 1 presents the summary statistics relative to the aid variable. Since we
are interested in threshold values, it is obvious that we need to first assess the
distribution of the data we are using. As can be seen, about half of the
observations display an aid to GDP ratio below 1.5 %, and only 5 % of the
sample have values over 10 %. The mean value of 2.9 % is below the sample
mean reported by Rajan and Subramanian (2008) which could be explained by the
fact that we use a larger sample, including developing countries which receive
little aid relative to their GDP. On the other hand, the few aid recipients which
display a high aid ratio have been dropped from our dataset due to the lack of data
for the control variables.

4 Estimation results

4.1 Benchmark values: fixed effects and GMM

In this first part, we try to investigate how the inclusion of interactive variables in
the classical growth equation can help us understand the nature of the apparently
complex relationship between aid and growth. It also provides us with benchmark
values to assess the performance of semi-parametrical techniques compared to more

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Table 2 Aid disbursements and growth, assessing nonlinearities using panel fixed effects and system
GMM, 1970–2009, four-year averages
1 2 3 4 5 6
FE S-GMM FE S-GMM FE S-GMM

Log initial per capita GDP 0.923 5.034 1.186 5.029 0.583 4.160
(1.037) (3.493) (1.025) (3.758) (1.003) (4.072)
EVI 0.053 0.062 0.059 0.069 -0.011 0.016
(0.037) (0.185) (0.037) (0.144) (0.058) (0.134)
HAI -0.053 -0.215 -0.047 -0.243 -0.056 -0.174
(0.053) (0.139) (0.050) (0.167) (0.054) (0.151)
Polity 0.015 -0.097 0.004 -0.115 0.007 -0.067
(0.046) (0.177) (0.043) (0.143) (0.048) (0.122)
M2/GDP -0.048 -0.157 -0.049 -0.135 -0.046 -0.142
(0.019)** (0.099) (0.018)*** (0.096) (0.019)** (0.112)
Inflation -0.033 -0.007 -0.031 -0.007 -0.041 -0.028
(0.022) (0.085) (0.022) (0.084) (0.022)* (0.080)
Government -0.168 0.025 -0.178 0.061 -0.176 -0.044
Expenditures/GDP (0.057)*** (0.266) (0.057)*** (0.198) (0.057)*** (0.218)
Magnitude of conflicts 0.028 -0.149 0.031 -0.130 0.032 -0.136
(MEPV) (0.053) (0.194) (0.052) (0.183) (0.052) (0.158)
Aid/GDP 9.004 -7.270 62.642 77.493 -79.785 -67.833
(12.493) (44.062) (29.953)** (89.197) (53.322) (111.792)
Aid/GDP2 -357.623 -508.824
(195.228)* (546.342)
Aid/GDP 9 EVI 1.780 0.999
(1.182) (2.065)
Constant -2.164 -27.359 -5.763 -27.359 3.814 -18.446
(7.938) (35.602) (7.951) (35.602) (7.492) (34.587)
Test for AR(2) (p-value) 0.649 0.686 0.821
Hansen J test (p-value) 0.664 0.614 0.602
Observations 531 531 531 531 531 531
Number of countries 89 89 89 89 89 89

Standard errors in parentheses

* Significant at 10 %
** Significant at 5 %
*** Significant at 1 %

standard econometrics. Table 2 displays panel fixed effects estimation results. The
use of fixed effects estimations is not ideal considering the potential endogeneity
issue between aid and growth. Nevertheless, the common remedy, instrumental
variables, is very difficult to implement once interactive values are included. To
control for endogeneity, system GMM results are also provided in Table 2.
While aid to GDP does not appear to be significant in the first two columns (as
shown in Table 2), there is some evidence that the relationship is actually nonlinear.

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The results in column 3 are easy to interpret and imply that there are decreasing
returns to aid (with an unconditional threshold value of 8.7 %). Nevertheless, these
findings are clearly not robust, as the results are no longer significant once we
control for the endogeneity of aid in column 4. As some nonlinearities seem to be
present in this first analysis, the robustness of the findings is questionable, and the
inclusion of second, third and fourth order terms does not seem to be sufficient to
represent the complex aid to growth relationship (see columns 1–4 in Table 5 in the
‘‘Appendix’’).
One possible explanation, as highlighted by Burnside and Dollar (2000) and
Guillaumont and Chauvet (2001), is that the effectiveness of aid is conditional on
other factors, namely institutional quality and economic vulnerability. Looking first
at economic vulnerability, we add into the empirical specification an interactive
variable between aid and Economic Vulnerability Index (EVI). As can be seen in
columns 5 and 6 of Table 2, the sole inclusion of this interactive variable is not
sufficient to find a significant threshold.
Very interesting results were obtained by including simultaneously two kinds of
nonlinearities. In columns 1 and 2 of Table 3, we introduce aid, its squared value,
and also the interactive variable between aid and EVI. In this case, both the
conditional and the unconditional thresholds turn out significant. This finding is
confirmed in columns 3 and 4, where we introduce aid 9 EVI and its own squared
value. By doing so, the three aid related coefficients aid, aid 9 EVI, and aid 9 EVI
squared turn out to be significant, with the expected sign.
These results hold using fixed effects and system GMM. Our interpretation of
these results is that the aid to growth relationship is characterized by the presence of
multiple thresholds whose values are influenced by structural characteristics and in
particular by economic vulnerability.
The results obtained by interacting our institutional quality variable and aid using
fixed effects and system GMM are provided in the ‘‘Appendix’’ (Table 5). Contrary
to Burnside and Dollar (2000), but in line with Rajan and Subramanian (2008), there
is little conclusive evidence that institutional quality influences the relationship
between aid and growth. The same results are obtained using alternative measures
of institutional quality. Comparable results using the civil liberties and political
rights variables from Freedom House are available upon request.

4.2 Semi-parametric estimations

While accounted for to some extent in the previous tables, nonlinearities seem to be
too complex to be captured through parametric estimators. In column 1 of Table 3,
we test the specification displayed in column 1 of Table 2 using a generalized
additive partially linear model. All parameters are estimated parametrically except
for Aid/GDP. We also include individual dummies to control for heterogeneity. We
rely on thin plate regression splines as the basis for our GAPLM formulation. Using
a v2 test comparing the deviance between the full model and the model without the
nonlinear component, it appears that the smoothing term is significant at the 5 %
level, with a p value of 0.02. In the same vein, Fig. 1 also provides Bayesian
confidence intervals for the smoothing term. Our estimation strategy allows us to

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Table 3 Aid disbursements and growth, assessing nonlinearities using panel fixed effects and system
GMM, 1970–2009, four-year averages
1 2 3 4
FE S-GMM FE S-GMM

Log initial per capita GDP 0.791 3.212 0.634 3.746

(0.969) (2.146) (0.965) (2.945)
EVI -0.064 -0.115 -0.071 -0.102
(0.050) (0.121) (0.052) (0.118)
HAI -0.047 -0.157 -0.051 -0.155
(0.053) (0.131) (0.053) (0.120)
Polity -0.026 -0.191 -0.013 -0.160
(0.045) (0.139) (0.045) (0.113)
M2/GDP -0.046 -0.136 -0.047 -0.111
(0.018)** (0.061)** (0.018)** (0.064)*
Inflation -0.043 -0.020 -0.041 -0.025
(0.021)** (0.073) (0.021)* (0.064)
Government -0.205 0.003 -0.198 0.005
Expenditures/GDP (0.056)*** (0.163) (0.056)*** (0.150)
Magnitude of conflicts 0.044 -0.069 0.041 -0.032
(MEPV) (0.049) (0.117) (0.050) (0.109)
Aid/GDP -57.717 -104.890 -126.287 -315.239
(46.328) (117.107) (50.384)** (156.988)**
Aid/GDP2 -760.535 -1,084.285
(200.717)*** (541.862)**
Aid/GDP 9 EVI 3.624 5.421 4.627 8.739
(1.137)*** (3.086)* (1.399)*** (3.843)**
(Aid/GDP 9 EVI)2 -12.567 -0.292
(3.822)*** (0.123)**
Constant 2.356 -11.970 4.484 -17.233
(7.079) (23.457) (7.049) (16.153)
Test for AR(2) (p-value) 0.599 0.600
Hansen J test (p-value) 0.673 0.640
Observations 531 531 531 531
Number of countries 89 89 89 89

Standard errors in parentheses

* Significant at 10 %
** Significant at 5 %
*** Significant at 1 %

obtain a significant and more complex nonlinear pattern than a specification with
only a squared term on a large set of data.
The first implication of this graphical representation is that it confirms both the
‘‘Laffer curve’’ view of Lensink and White (2001), and the minimum effort curve of

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Fig. 1 Estimation of the nonlinear effect of aid on GDP growth. The graph shows the estimate of the
function f(AID) using GAPLM with thin plate regression splines as basis. The dashed curves represent the
5 % Bayesian confidence interval. (Source: author’s calculations)

Gomanee et al. (2003). Hence the aid to growth relationship increases up to around
2 % for a low level of aid flows. Then it remains relatively constant, with a
threshold at around 6 %, where the marginal returns increase. This pattern matches
Gomanee et al’s (2003) findings. There appears to be a need for a minimum level of
aid flows for aid to significantly stimulate economic growth.
Our results support the ‘‘Big Push’’ theory, which states that a scaling up of aid is
required to escape the ‘‘poverty trap’’, or that only a large inflow of aid can
overcome the structural rigidities, or the fixed costs implied by the management of
aid. We cannot investigate the reasons for such findings here. However, as aid flows
reach around 11 % of a country’s GDP, the marginal returns decrease. Even if the
significance level of our nonlinear trend decreases sharply, there is evidence that an
increase of aid might become harmful to growth for a high level of ODA to GDP
ratio all other things being equal.
This second point confirms the idea that aid above some level displays
diminishing returns, leading to an aid ‘‘Laffer curve’’, which reflects the limited
absorptive capacity of recipient countries, due to capacity constraints, ‘‘Dutch
disease’’ reactions, or other factors (as analysed in Guillaumont and Guillaumont
Jeanneney 2006, 2010). The overall conclusion we can draw from this graph is that
even if the pattern of the curve supports our hypothesis of multiple thresholds, only
a small part of aid distribution seems to be really effective according to the rather
large confidence interval. Nevertheless, we have to keep in mind that the Net ODA
to GDP variable that we use is undoubtedly a very ‘‘mixed bag’’ and that we have to
expect the significance level to be quite low as all aspects of aid do not have a direct
impact on growth.

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Even if the estimation strategy is substantially different from the rest of the
literature, the endogeneity issue is still troublesome. We show in Table 2 that the
significance of the multiplicative variable tends to decrease when using system GMM.
As shown by Sperlich (2005), it is possible to obtain consistent GAPLM estimates by
using instrumental variables in a two-step procedure that is close to the classical 2SLS
estimator. This approach only requires a non-parametric, a semi-parametric or even a
parametric construction of the regressors of interest in the first step. In order to stay as
close as possible to the current state of the art, we choose to use the instruments
proposed by Tavares (2003). First, we select the 11 largest OECD donors (Australia,
Canada, France, Germany, Italy, Japan, Korea, the Netherlands, Spain, the United
Kingdom and the United States). Then, for each donor-recipient pair we compute,
four variables that capture geographic and cultural proximity. We use the inverse of
the bilateral distance, and three dummy variables—for common land border, same
majority religion and same official language. For each year and each pair we multiply
our four cultural variables by the constant US dollar value of aid flows. Finally, for
each developing country and each year, the sum of aid flows gives us four
instrumental variables. These four variables represent the share of ODA that is
allocated by the largest bilateral donors for cultural and strategic reasons without
respect to needs. Results using this new aid variable are displayed in Table 4 column
2 and Fig. 2. As shown earlier, once aid is instrumented, the significance of the
relationship, either linear or nonlinear, between aid and growth tends to reduce.
Nevertheless, using fixed effects and GMM estimations we find that the only
robust and significant nonlinearities involve a mix between diminishing returns and
conditional effects with respect to EVI.3 Guillaumont and Chauvet (2001) and
Chauvet and Guillaumont (2004, 2009) state that economic vulnerability is one of
the main factors conditioning aid effectiveness. For countries suffering from such
vulnerability, foreign aid allows the effects of negative shocks to be dealt with more
effectively. So aid is assumed to smooth public expenditure, to stabilize budget
balance, and to some extent help to avoid the economic and social collapses, which
can often result from shocks in low income countries. Accordingly, the marginal
returns of aid must be higher for the most vulnerable countries, or they may
decrease less rapidly, as found by Guillaumont and Laajaj (2006) in an analysis of
the factors determining the rate of success of World Bank projects. Instead of
estimating a linear coefficient for the policy variable and the smoothing function
f(Aid), we specify a smoothing function with two components f ðAid; EVI Þ. The
convenience and flexibility of the GAPLM formulation is made quite clear in this
case, when compared to more classical estimations for which we would have to
include arbitrarily numerous multiplicative and squared terms as we did in Table 2.
As the two variables are not on the same scale, we do not expect the same degree of
smoothness to be appropriate for both covariate axes. Hence, following Wood
(2006), we choose to rely on tensor product smoothing rather than on isotropic
smoothing. The smoothing of the function f ðAid; EVI Þ is then a tensor product of
3
The same tests were conducted by specifying the following smoothing function f ðAid; PolityÞ,
interacting aid and the institutional quality index. Results (available upon request) confirm those provided
in the ‘‘Appendix’’ using parametric methods. There is no evidence that institutional quality influences aid
effectiveness.

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Identifying thresholds in aid effectiveness 631

Table 4 Aid disbursements and growth, assessing non-linearities using GAPLM, 1970–2009, four-year
averages

1 2 3 4

Constant -2.776 0.314 -0.051 -0.769

(6.477) (6.410) (6.395) (6.360)
Log initial per capita GDP 1.245 1.288 1.421 1.504
(1.125) (0.857) (0.872) (0.869)
EVI 0.045 0.022
(0.037) (0.039)
HAI -0.014 -0.024 -0.032 -0.024
(0.044) (0.045) (0.044) (0.045)
Polity 0.001 0.015 0.044 0.007
(0.045) (0.044) (0.045) (0.044)
M2/GDP -0.042 -0.056 -0.040 -0.056
(0.017)** (0.018)*** (0.017)** (0.018)***
Inflation -0.030 -0.034 -0.046 -0.045
(0.020) (0.020)* (0.020)** (0.020)**
Government -0.173 -0.185 -0.202 -0.191
Expenditures/GDP (0.051)*** (0.051)*** (0.050)*** (0.051)***
Magnitude of conflicts (MEPV) 0.040 0.036 0.059 0.046
(0.056) (0.056) (0.059) (0.056)

f(AID) f(AID) f ðAid; EVI Þ f ðAid; EVI Þ

Is aid instrumented? No Yes No Yes

Approximate significance of the 0.027** 0.265 6.24e - 05*** 0.010***
smoothing term (p-value)
Estimated degrees of freedom 3.75 1.877 10.96 6.081
Observations 531 531 531 531
Number of countries 89 89 89 89
R2 (adj) 0.349 0.338 0.377 0.353

Standard errors in parentheses; Each specification includes period and individual fixed effects
* Significant at 10 %
** Significant at 5 %
*** Significant at 1 %

two thin plate regression splines. These results are reported in Table 4 column 3 and
in Fig. 3.
The 3D graphical representation in Fig. 3 can easily be compared to the two-
dimensional representation in Fig. 1 as it tends to display the same pattern with
respect to the level of the aid to GDP ratio. However, it also shows how the aid to
growth relationship interacts with economic vulnerability. At a low level of
economic vulnerability, the impact of aid is limited when aid is below 2 % of GDP.
As it goes above 2 %, marginal returns become negative and aid appears to be
harmful to growth. For countries with higher economic vulnerability, the threshold

123
632 L. Wagner

Fig. 2 Estimation of the nonlinear effect of aid (once instrumented) on GDP growth. This graph shows
the estimate of the function f(AID) using GAPLM with thin plate regression splines as the basis. The
dashed curves represent the 5 % Bayesian confidence interval. (Source: author’s calculations)

Fig. 3 Aid marginal response

with respect to EVI. This graph
shows the estimate of the
function f ðAid; EVI Þ using
GAPLM, with tensor products of
thin plate regression splines as
the basis, for the available data.
The parametric variables of the
estimated equation are evaluated
at their sample mean. The
Bayesian confidence interval is
not reported for the sake of
clarity (Source: author’s
calculations)

value corresponding to the capacity constraint hypothesis tends to rise to about

12 %. These results are to be taken with caution as they may be influenced by
endogeneity. The final column of Table 4 and Fig. 4 display estimation results of
the function f ðAid; EVI Þ where Aid is, as in column 2, corrected for endogeneity.
This last estimation represents in our mind the main contribution of our study as it
represents in a simple diagram the complex interaction between aid, growth and

123
Identifying thresholds in aid effectiveness 633

Fig. 4 Instrumented aid

marginal response with respect
to EVI. This graph shows the
estimate of the function
f ðAid; EVI Þ using GAPLM, with
tensor products of thin plate
regression splines as the basis,
for the available data. The
parametric variables of the
estimated equation are evaluated
at their sample mean. The
Bayesian confidence interval is
not reported for the sake of
clarity (Source: author’s
calculations)

economic vulnerability as previously suggested by Guillaumont and Guillaumont

Jeanneney (2010). It also allows us to reconcile in a common framework the ‘‘Big
Push’’ hypothesis with the notion of capacity constraint. For countries with a low level
of vulnerability, aid has a significant impact on growth, whereas the marginal
effectiveness of aid rapidly decreases and becomes negative as the ratio of aid to GDP
rises above 2 %. The magnitude of this effect decreases as the level of vulnerability
increases. On the other hand for vulnerable countries, at a low level of aid to GDP, the
marginal impact in terms of growth is close to zero or negative. But as the level of aid
rises above 2 %, marginal returns become positive, and the impact of aid on growth
increases as aid increases. This 2 % threshold is consistent with the finding of
Gomanee et al. (2003). Nevertheless, marginal returns become negative as the aid to
GDP ratio goes over 12 % as vulnerable countries reach their own capacity constraint.
For vulnerable countries, we can clearly see two thresholds. The first one is
related to the ‘‘Big Push’’ theory implying that there is a level of minimum effort by
the donor community that has to be made to produce positive effects on growth. The
second one illustrates the capacity constraint issues. These results are very close to
the findings reported in Guillaumont and Laajaj (2006) when examining the rate of
success of World Bank projects for a large number of countries. They showed that
the average success rate of projects was 15 points higher in an economically stable
country. They also showed that while this rate of success decreases rapidly in stable
countries as aid level rises, it was not the case for unstable countries, which suggests
a stronger absorptive capacity. The key lesson to be drawn from this last graph is
that while the aid to growth relationship is nonlinear, the values of the different
thresholds vary according to structural characteristics, and in particular according to
economic vulnerability. The stabilizing effect of aid in supporting vulnerable
countries to cope with negative exogenous shocks tends to increase the threshold of
absorptive capacity. This graph also helps us understand why the inclusion of aid in
a simple growth equation has led to inconsistent results in previous studies. As we

123
634 L. Wagner

saw earlier, half of our sample displays an aid to GDP ratio lower than 2 %. This
means that half of our sample presents very different marginal returns of aid to
growth according to their level of economic vulnerability. Without taking into
account nonlinearities, according to the estimation sample used one can draw very
different conclusions about the effectiveness of aid. Finally, the conclusions drawn
from the GMM estimations in Table 5 in the ‘‘Appendix’’, the GAPLM results
interacting ODA over GDP, and the quality of institutions (available upon request)
are very similar. Using OLS, GMM and GAPLM, we were unable to find significant
evidence that institutional quality influences the effectiveness of aid.

5 Conclusions

Concluding their 2001 paper, Hansen and Tarp (2001) stated that ‘‘We also note that
empirical conclusions about aid effectiveness that are based on cross-country
growth regressions depend on poorly understood nonlinearities and critical
methodological choices’’. Guillaumont and Guillaumont Jeanneney (2010) high-
lighted that the inclusion of an aid-squared term (and a cubed one) in the classical
aid to growth equation was not appropriate to discover the nature of the
nonlinearities crucial for this particular relationship. Our attempt to address the
no-linear pattern of the aid to growth relationship may overcome some of the main
drawbacks highlighted previously. The methodology presented here allows us to
investigate graphically nonlinearities without making any assumptions on the nature
of the nonlinear trend. We show that the aid to growth relationship is highly
nonlinear with two clear thresholds. The first threshold confirms the view of
researchers who support the ‘‘Big Push’’ theory. It appears that many countries do
not experience positive and significant marginal returns from aid because they are
just not receiving enough of it. However, because a second threshold exists which
confirms the hypothesis of limited absorptive capacity, our results also suggest that
for very high levels of aid the marginal returns decrease and might even become
negative. Furthermore, the level of economic vulnerability appears to be critical in
understanding how growth responds to aid flows. Our results support the view that
aid is more useful in countries where vulnerability is high. They also show that
countries with high economic vulnerability may suffer from negative returns of aid
when aid is at a low level, because the stabilizing effect of aid is not enough to deal
with exogenous shocks. Finally, our results enable us to show that the aid to growth
relationship is complex, and help us to understand the difficulties that researchers
have faced in their numerous attempts to estimate it.

Acknowledgments This paper benefited from the financial support of the FERDI (Fondation pour les
Etudes et Recherches sur le Développement International) and of the programme ‘‘Investissements
d’Avenir’’ (reference ANR-10-LABX-14-01) of the French Government. The author thanks an
anonymous referee for helpful comments and valuable discussions.

Appendix

See (Table 5).

123
 Table 5 Aid disbursements and growth, assessing nonlinearities with respect to institutional quality, 1970–2009, four-year averages
1 2 3 4 5 6 7 8
FE S-GMM FE S-GMM FE S-GMM FE S-GMM

Log initial per capita GDP 1.317 2.635 1.558 2.573 0.956 3.442 1.245 4.334
(1.047) (2.153) (1.035) (2.123) (1.058) (2.319) (1.040) (2.496)*
EVI 0.057 0.010 0.054 0.017 0.049 0.057 0.054 0.047
(0.039) (0.054) (0.039) (0.055) (0.039) (0.079) (0.038) (0.080)
HAI -0.048 0.039 -0.058 0.053 -0.052 -0.127 -0.046 -0.144
(0.050) (0.087) (0.050) (0.143) (0.053) (0.116) (0.051) (0.155)
Polity -0.002 -0.165 0.002 -0.124 -0.010 -0.117 -0.030 -0.122
Identifying thresholds in aid effectiveness

(0.044) (0.095)* (0.045) (0.073)* (0.054) (0.145) (0.053) (0.141)

M2/GDP -0.049 -0.009 -0.047 0.000 -0.047 -0.086 -0.047 -0.041
(0.018)*** (0.057) (0.018)*** (0.041) (0.019)** (0.071) (0.018)** (0.066)
Inflation -0.032 -0.009 -0.031 -0.009 -0.036 -0.012 -0.034 -0.026
(0.022) (0.064) (0.022) (0.046) (0.023) (0.062) (0.022) (0.063)
Government expenditures/GDP -0.181 0.032 -0.168 0.021 -0.177 0.042 -0.190 0.072
(0.057)*** (0.136) (0.057)*** (0.132) (0.063)*** (0.170) (0.063)*** (0.120)
Magnitude of conflicts (MEPV) 0.032 -0.067 0.039 -0.119 0.024 -0.118 0.027 -0.109
(0.052) (0.131) (0.051) (0.108) (0.054) (0.101) (0.053) (0.122)
Aid/GDP 89.595 115.691 227.996 7.484 9.741 -16.445 66.465 51.075
(55.586) (111.112) (87.859)** (171.801) (13.427) (31.862) (30.427)** (76.799)
Aid/GDP2 -822.970 -1,815.521 -5,238.638 1,760.225 -376.642 -371.758
(752.093) (1,466.731) (2,419.177)** (4,248.881) (198.172)* (403.849)
Aid/GDP3 2,165.991 7,539.635 49,916.543 -30,111.751
(3,026.127) (6,327.722) (25,854.791)* (41,600.784)
4
Aid/GDP -160,424.475 116,589.639
(86,364.302)* (129,828.500)
635

123
 Table 5 continued
636

1 2 3 4 5 6 7 8
FE S-GMM FE S-GMM FE S-GMM FE S-GMM

123
Aid 9 PolityIV 0.696 0.304 0.917 0.747
(1.133) (1.897) (1.005) (2.418)
Constant -6.937 -27.016 -9.408 -27.321 -2.176 -20.885 -5.970 -31.048
(8.099) (19.644) (8.160) (21.265) (7.935) (17.436) (7.950) (18.202)*
Observations 531 531 531 531 531 531 531 531
Test for AR(2) (p-value) 0.202 0.159 0.491 0.360
Hansen J test (p-value) 0.233 0.462 0.652 0.232

Standard errors in parentheses

* Significant at 10 %
** Significant at 5 %
*** Significant at 1 %
L. Wagner
Identifying thresholds in aid effectiveness 637

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