Unintended consequences of externally aided projects on fiscal transfers: a subnational study of India

We investigate the impact of foreign aid on inter-governmental transfers in India. While anecdotal evidence suggests that the central government substitutes fiscal transfers with earmarked foreign aid for state governments (fungibility), empirical evidence is scant due to the complex procedure of accruing foreign aid by the states. By Constitutional design, all foreign aid projects procured by states accrue to the central government which are then distributed to states as Additional Central Assistance (ACA) on Externally Aided Projects (EAPs). Analysing panel data covering 29 states from 1979 to 2017, we find that EAPs per capita are positively associated with the central government fiscal transfers to states under discretionary head (resource loading), but not with formulaic transfers. Importantly, the positive effect of EAPs on discretionary transfers is contingent on political alignment between the central and state governments, a finding consistent with previous works that demonstrate how recipient governments target aid at the subnational level based on local political factors. These findings have significant policy implications for the centre, state governments, and external aid donors.