Do donors allocate aid according to development needs or according to their own interests?

Previous studies into aid allocation found that foreign aid is allocated not only according to the needs and merits of the recipient country but also according to the donors' self-interest. We revisit this topic using a large, three-dimensional dataset covering the period 1980-2004. By controlling for time-invariant donor and recipient effects, we analyse the differences in foreign aid allocation between the top five donors and how they differ from the average DAC donor. We go beyond the analysis of previous research by assessing the relative importance of recipient need and merit relative to donor self-interest. Our results show that unobserved recipient effects are very important in the allocation of aid, suggesting that we still have a poor understanding of donor behaviour. Analysing the effect of observed variables on the allocation of aid, we find strong evidence that donors act out of self-interest. All donors provide more aid to trade partners and the UK as well as the US provide more aid to recipients who vote with them at the UN. We also find that donors take recipient need into consideration. The estimated income elasticity is about minus one for all donors apart from the UK, where the elasticity is considerably larger (about -1.8). However, we find limited evidence that donors allocate aid according to recipient merit. Only the UK and Japan provide more aid to countries with higher higher democracy scores. Germany, France and Japan give more to countries with fewer human rights abuses. The US seems to place no importance on recipient merit. However, these are among the only factors that developing countries have the ability to change in the short to medium term. With respect to receiving more aid, recipients have very little incentive to initiate reform.