The effect of foreign aid on economic growth, poverty, and developmental outcomes may depend heavily on the fiscal response of recipient governments. One aspect of this fiscal response is the possibility that aid may be fungible (i.e., the net effect of earmarked aid differs from the intended effect).

This paper endeavors to determine the extent to which earmarked education and health aid are fungible. Many studies of foreign aid fungibility are hampered by a lack of comprehensive data pertaining to the intended purpose of aid. I use the OECD’s Creditor Reporting System (CRS), which disaggregates aid by sector, to overcome this problem. To cope with the incompleteness of the CRS data, I propose a novel data construction method that begins with the CRS and adds information from other OECD aid databases to provide more complete measures of education and health aid disbursements.

These data also enable me to divide education and health aid into on- and off-budget components. I demonstrate how a failure to adequately deal with off-budget aid (aid that is not recorded in a recipient government’s budget) may have biased previous estimates of fungibility. When donor-based measures of aid are employed, a potentially large fraction of this aid is off-budget aid. Hence, even if aid is used in the targeted sector, some of it may not be recorded as the sectoral expenditures of a recipient government. This failure to record some aid reduces the estimated marginal effect of total sectoral aid on government sectoral expenditures and thus leads to an overestimation of the extent of fungibility. Other papers employ aid data that are reported by recipient governments. In this case, the effect of on-budget aid on government expenditures is estimated, and off-budget aid acts as an omitted variable. Hence, the first problem is that we cannot estimate the degree of fungibility of off-budget aid. Moreover, because off- and on-budget aid are likely correlated, the estimated effect of on-budget aid is biased unless the marginal effect of off-budget aid on government spending is zero.

I use sector program (SP) aid as a measure of on-budget aid and technical cooperation (TC) as a proxy for off-budget aid. Fixed effects (FE) results illustrate the need to consider on- and off-budget aid separately. In both sectors, SP aid has an approximately one-to-one correlation with the public sectoral expenditures of recipient countries. For TC, the proxy for off-budget aid, the same result of limited fungibility is found: its coefficient is close to and typically not significantly smaller than zero, indicating that TC does not displace recipients’ own public spending in either sector. The result of limited fungibility for TC, which constitutes the bulk of total education and health aid, is robust across a range of specifications. In contrast, although the effect of SP aid is robust in the context of a static panel data model that is estimated with FE, the coefficient of SP aid becomes imprecise and volatile in a dynamic model that is estimated with system GMM because of the lack of variation in SP aid.

This paper follows the example of Feyzioglu, Swaroop, and Zhu (1998) and Devarajan, Rajkumar, and Swaroop (2007), among others, in estimating the degree of fungibility from a panel consisting of a large number of countries. For each country, the maximum time span for which data on both government education/health 1