Using aid to subsidise private investment

Justin Muzinich and Eric Werker propose “a better approach to foreign aid” in the form of tax credits for companies that invest in developing countries:

tax credits for U.S. companies promise more aid, less waste, and the hope of better institution-building than government-to-government assistance. The next question is how a system of tax credits should be designed — which sorts of investments should qualify for credits, which countries should be eligible to benefit from them, and what the total size of the program should be.

Though the argument is based on utterly false premises, there may be some merit in the idea.

The authors claim that most aid is not spent prudently because it goes on “debt service, consultants and humanitarian emergecies …. mismanagement and corruption” while “American markets reward companies if they use capital efficiently”.

It is true that about 7% of global aid goes on humanitarian relief – and so it should. Following the floods in Burma, and the earthquake in China, or the failure of the harvest in Somalia and Ethiopia, it is right that some aid is targeted at alleviating the resulting human suffering. It is also true that about 18% of aid is used for debt relief – which frees developing countries from servicing debt, and so allows them to spend that money on investment in economic growth and for social services. And consultants are often part of technical assistance (which is 21% of aid): this is righly criticised for being less effective than it should be, but most of us think that sharing knowledge is nevertheless an important and desirable part of foreign assistance. So to denounce these as not “prudent” is plain ignorant.

That said, we may be missing a trick. We tend to think that where markets fail, governments must provide. But we would get much more bang for our buck if we used aid to sweeten the deal for private firms, tipping an “uneconomic” investment (in terms of private returns) in services for poor people into an economic one. Paying the margin to make an investment worthwhile, rather than meeting the entire economic cost of the service, could enable limited aid budgets to go much further.

What we need to avoid, as ever, is state subsidies that create fat, lazy incumbent firms that are free from innovative and dynamic competitors.

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