Foreign aid in Papua New Guinea (PNG) has been heavily criticised on the grounds that it has undermined incentives for domestic revenue collection, encouraged irresponsible expenditure behaviour and high levels of public debt, and contributed to the poor composition of government spending towards wasteful expenditure items. This paper seeks to determine what impact foreign grants have had on the fiscal behaviour of the PNG Government with the use of a dynamic Vector Error Correction Model which estimates a simultaneous system of fiscal equations between 1974 and 2008. Results show that foreign grants have indeed lowered domestic revenue collection but they have also been an important source of debt reduction. In some circumstances aid has improved the composition of government expenditure but the revenue and debt repayment effects mean that it has had a weak effect on increasing overall expenditure levels. Preliminary results also suggest that these effects vary considerably according to how aid is delivered, comparing budget support vis-à-vis project and program aid delivery. A number of policy implications follow.

This item was commisioned by Crawford School of Economics and Government, ANU