metadata: authors: 0: author: Agenor,Pierre-Richard
1: author: Bayraktar,Nihal
2: author: Pinto Moreira,Emmanuel
count: World,Niger
docna: 0: docna: Linking public investment programs and SPAHD
            macro models : methodology and application to aid requirements
docty: Policy Research Working Paper
subtopic: Health Care Services Industry,Reproductive Health,Early Child and Children's Health,Educational Sciences,Hydrology,Inequality
teratopic: Macroeconomics and Economic Growth,Public Sector Development,Health, Nutrition and Population
abstracts: cdata!: The authors propose a "bottom
            up" approach to link public investment programs with a
            class of macro models recently developed to quantify
            Strategy Papers for Human Development (SPAHD) in low-income
            countries. The methodology involves establishing
            constant-price projections of investment outlays
            (disaggregated into infrastructure, education, and health),
            spending on maintenance and other goods and services,
            salaries, and user charges. These estimates are incorporated
            in a SPAHD macro framework to calculate, under alternative
            scenarios, domestic financing, foreign borrowing, and aid
            requirements. The authors also evaluate the impact on growth
            and indicators associated with the Millennium Development
            Goals. They use illustrative applications, based on a SPAHD
            model for Niger, to highlight the link between tax reform
            and aid requirements.
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repnme: repnme: Linking public investment programs and
            SPAHD macro models : methodology and application to aid requirements
display_title: Linking public investment programs
            and SPAHD macro models : methodology and application to aid requirements
listing_relative_url: /research/2006/06/6889027/linking-public-investment-programs-spahd-macro-models-methodology-application-aid-requirements
topicv3: Water m1326522 137,Infant and Child Mortality m1326544 1446,Poverty m1326687 695,Education m1327048 470,Health m1504661 3480
publishtoextweb_dt: 2010-07-01T00:00:00Z
historic_topic: Macroeconomics and Economic Growth,Public Sector Development,Health, Nutrition and Population
no_of_pages: 31
author_keys: 0: author_key: 177753
1: author_key: 167915
2: author_key: 455429
model_extractions: WPS3944 1

# **Linking Public Investment Programs and SPAHD Macro Models**

## **Methodology and Application to Aid Requirements**

### Pierre-Richard Agénor<sup>a</sup> , Nihal Bayraktar<sup>b</sup> , and Emmanuel Pinto Moreira<sup>c</sup>

## **Abstract**

This paper proposes a “bottom up” approach to link public investment programs with a class of macro models recently developed to quantify Strategy Papers for Human Development (SPAHD) in low-income countries. The methodology involves establishing constant-price projections of investment outlays (disaggregated into infrastructure, education, and health), spending on maintenance and other goods and services, salaries, and user charges. These estimates are incorporated in a SPAHD macro framework to calculate, under alternative scenarios, domestic financing, foreign borrowing, and aid requirements. The impact on growth and indicators associated with the Millennium Development Goals are also evaluated. Illustrative applications, based on a SPAHD model for Niger, are used to highlight the link between tax reform and aid requirements.

#### World Bank Policy Research Working Paper 3944, June 2006

_The Policy Research Working Paper Series disseminates the findings of work in progress to encourage the exchange of ideas about development issues. An objective of the series is to get the findings out quickly, even if the presentations are less than fully polished. The papers carry the names of the authors and should be cited accordingly. The findings, interpretations, and conclusions expressed in this paper are entirely those of the authors. They do not necessarily represent the view of the World Bank, its Executive Directors, or the countries they represent. Policy Research Working Papers are available online at http://econ.worldbank.org._ aHallsworth Professor of International Macroeconomics and Development Economics, University of Manchester, and co-Director, Centre for Growth and Business Cycle Research; bAssistant Professor, Penn State University and World Bank; and cSenior Economist, World Bank. Some of the ideas presented in this paper were developed in the context of a joint World Bank-United Nations Development Program (UNDP) technical assistance project for Niger.
# **Contents**

- I.    Introduction

- II.    Methodology

1.  Case of Exogenous Aid

2. Public Investment Programs and Aid Requirements 3. Link with a Medium-Term Budget

- III.    Applications

1.  An Illustrative Public Investment Program

2. Aid Requirements and the Medium-Term Budget Framework 3. Tax Reform and Aid Requirements

- VI.    Concluding Remarks

References Appendix —SPAHD Macro Models: Structure and Link with the MDGs Tables Figures 2
# **I.  Introduction**

Promoting a large increase in public investment is increasingly recognized as a critical step to spur growth, reduce poverty, and improve the quality of human life of low-income countries. Indeed, a number of recent reports—such as those of the United Nations Millennium Project (2005), the Blair Commission (2005), and the World Bank (2005)—have called for a “Big Push” in public investment in education, health and infrastructure, financed by generous debt relief and a large increase in foreign aid, given the limited ability of the poorest countries to raise resources through domestic taxation or borrowing.<sup>1</sup> More specifically, the declaration adopted at the UN World Summit of September 2005 called on all countries“ to adopt, by 2006 and implement comprehensive development strategies to achieve the internationally agreed development goals and objectives, including the Millennium Development Goals (MDGs).” What it means, essentially, is that the logic of aid allocation should be aligned squarely on what countries need to achieve their development objectives. This “new view” of aid raises a host of political economy issues (involving, for instance, the role and nature of conditionality), which have not been fully resolved; as a result, it is too early to tell whether donors’ behavior will be adjusted to respond to the new environment.

At a more technical level, however, a key issue raised by the “new view” of aid relates to the need to assess quantitatively requirements for foreign assistance, given a public investment program (PIP) and its impact on growth and the MDGs. Dwelling on some of our previous work, this paper proposes a “bottom up” approach to linking public investment programs with a class of macro models recently developed to quantify Strategy Papers for Human Development (SPAHD) in low-income countries. The methodology involves establishing

> 1Infrastructure plays a particularly important role in this context, in part because of its impact on health and education outcomes. See Agénor and Moreno-Dodson (2006) for a detailed discussion of the role of infrastructure in the growth process, and Agénor and Neanidis (2006) for a formal analysis in an endogenous growth framework.

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constant-price projections of investment outlays (disaggregated into infrastructure, education, and health), spending on maintenance and other goods and services, salaries, and user charges. These estimates are then incorporated into an appropriate macro framework to calculate, under alternative scenarios regarding domestic financing and foreign borrowing, aid requirements.

The remainder of the paper is organized as follows. Section II provides a formal description of the methodology. Section III applies the methodology to Niger, using an illustrative PIP. This section also shows how calculations of aid requirements depend on the assumed path of tax policy. Section IV provides some final remarks. We emphasize the fact that to ensure that the PIP is realistic and based on reliable data, substantial improvements in project assessment capability within the public sector may be required in many countries.

# **II.  Methodology**

The methodology that we propose in this paper builds on the SPAHD macroeconomic framework developed by Agénor, Bayraktar and El Aynaoui (2006), and extended by Pinto Moreira and Bayraktar (2005), and Agénor, Bayraktar, Pinto Moreira, and El Aynaoui (2005). This class of models, which is now commonly referred to as SPAHD macro models, provides a unique and tractable framework for accounting for the links between aid, public investment, — the supply side, and some key human development indicators including the poverty rate, malnutrition, the infant mortality rate, percentage of population with access to safe drinking water, the literacy rate, and life expectancy.<sup>2</sup>

> 2See the Appendix for a more detailed presentation of SPAHD macro models. The emphasis on public investment and the supply side in these models dwells on the more advanced class of IMMPA models, described in the collection of studies edited by Agénor, Izquierdo, and Jensen (2006). See also Agénor (2005) for a broader perspective on the design of macroeconomic models for poverty analysis.

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We begin by describing formally the treatment of public investment and budget financing in a SPAHD framework in the case where aid is treated “above the line” and considered exogenous. We then explain how to re-arrange these equations to solve residually for aid needs, given a PIP built from micro data.

# **1.  Case of Exogenous Aid**

In a standard SPAHD framework, aid (defined as grants only) is treated “above the line” and taken as exogenous, whereas all components of borrowing (concessional or not) are treated as financing items. In existing models, there is also an econometrically-estimated linking public investment in real terms, IG, with aid and domestic resources (taxes, for short): where AID is foreign aid (measured in domestic currency), TAX total taxes, and PQT the equivalent of the after-tax consumer price index. This equation is generally specified in proportion of GDP, but we use a “level” specification to simplify the presentation. Note also that in some applications, nonlinearities in the AID variable are also introduced in this relationship to capture absorption constraints.<sup>3</sup> Components of public investment consist of health, education, and infrastructure (ignoring, for simplicity, any residual category). Given the overall level of public investment determined from (1), these components are then calculated as fixed fractions:

> 3 See for instance the SPAHD model for Niger in Pinto Moreira and Bayraktar (2005).

5
where h = edu, hea, inf. In this expression, κh ∈ (0,1), and Σhκh = 1. Thus, we have also IG = ΣhIGh.

As discussed in Agénor, Bayraktar, Pinto Moreira and El Aynaoui (2005), we account for the possibility that a fraction of the resources invested in investment projects may not have a positive impact on public capital. Specifically, we follow the linear specification proposed by Arestoff and Hurlin (2005), which is based on a modified version of the perpetual inventory method: where αh ∈ (0,1) measures the degree of efficiency of investment category h, and δh ∈ (0,1) the rate of depreciation of capital h. The case of “full efficiency” corresponds therefore to αh = 1.

Total government spending at current prices is given by where WG·LEG denotes the wage bill, CG total spending on goods and services, and INT interest payments on domestic and foreign debt.

Real spending on goods and services, CG, consists of maintenance expenditure, MAINT, and other spending: In turn, maintenance spending, measured at constant prices, is taken to be proportional to total depreciation of physical capital: 6
where θM > 0.<sup>4</sup> As noted earlier, the government budget balance treats aid (grants) above the line, and all borrowing (concessional or not) below the line: Financing of the budget deficit is either from domestic borrowing, DB, or foreign borrowing, measured in domestic-currency terms, ER·FG: This equation is generally solved for the level of foreign borrowing (assumed to be at concessional terms).

Treating aid as exogenous in a typical exercise with a SPAHD macro model is warranted if the objective is, for instance, to assess whether large aid inflows (viewed as an exogenous impulse) can lead to an appreciation of the real exchange rate, given that demand- and supply-side effects tend to operate in opposite direction. However, to calculate aid requirements, the logic of the solution process described earlier must be amended.

# **2.  Public Investment Programs and Aid Requirements**

To alter the model structure outlined above and endogenize aid, the first step is to drop equation (1). We then treat IG as predetermined (taken from the PIP), and solve for aid as the budget equilibrating item. The starting point is thus

> 4Note that the coefficient θM may be greater than unity, if maintenance activities involve not only replacing the physical capital that is deteriorating but also other expenses associated with the delivery of these services (for instance, the cost of running a maintenance agency). See the discussion below.

7
the assumption that the PIP provides detailed multi-annual projections of capital outlays, maintenance costs, other spending on goods and services (such as, in the case of education, books, pencils, and uniforms), wages and salaries (such as teachers’ pay, in the case of education), and the direct revenues (fees) derived from public investments, all at constant prices.

First, suppose that the PIP provides estimates of required public investment needs in education, health, and infrastructure. In terms of the previous notation, the public investment program implies that Using (3), the stock of public capital in category h is thus given by Second, suppose that the PIP provides data on “new” requirements for maintenance at constant prices, NR_MAINT<sup>PIP</sup> . Using (6), total spending on maintenance is thus with KGh determined from (10).

Third, suppose that the PIP provides estimates of spending on goods and PIP services other than maintenance at constant prices, NR_CGoth . Using (5) and (11), total spending on goods and services at constant prices is now 8
Fourth, suppose that the PIP provides estimates of wages and salaries that will recur as a result of the new investment at constant prices, N_SAL<sup>PIP</sup> . Total wage payments at current prices is thus Fifth, suppose that the PIP provides estimates of user charges at constant prices that accrue directly to the budget (possibly through transfers from public enterprises), denoted by USER<sup>PIP</sup> .<sup>5</sup> Total government resources at current prices excluding aid, GOVR, are thus Substituting (9), (12) and (13) in (4) implies that total government spending implied by the PIP is For a given path of domestic and foreign borrowing (DB and ER·FG, respectively) aid requirements associated with the PIP can thus be calculated residually from equations (7), (8), (14), and (15): The foregoing discussion shows that the degree of efficiency of investment has only indirect effects on aid requirements. In particular, the lower is the efficiency parameter α in equation (10), the lower will total maintenance spending be in equation (11). From (12), (15) and (16), aid requirements will be

> 5User charges may be higher for some components of infrastructure (such as telecommunications or, to a lower extent, toll roads) than others (such as health services, for instance). It should also be kept in mind that even a small bill on public utilities may represent a substantial burden for poor households. In establishing projections in that area, it is therefore better to err on the side of caution.

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lower than otherwise. However, to the extent that lower efficiency of public investment translates into lower growth and revenues, aid requirements will increase. Thus, the net effect of an increase in efficiency on foreign assistance is in general ambiguous.

In the foregoing presentation, we have assumed that the PIP incorporates estimates of projected spending on _total_ wage payments at constant prices, N_SAL<sup>PIP</sup> . In principle, these estimates should be derived from the projected path of an “effective” average wage (at constant prices) on new hires, N_RWG<sup>PIP</sup> , PIP multiplied by the increase in public sector employees, N_∆LEG . Thus, instead of (13), total wage payments at current prices would be given by From the point of view of fiscal accounting, decomposing the projected wage bill of the public sector into movements in an effective wage and changes in employment may not matter too much, given that both variables are treated as predetermined in our approach. However, from the perspective of the labor market, this decomposition could be quite important. The reason is that hiring by the public sector affects the composition of labor supply in the economy, and could therefore have significant implications for the private sector. A sharp increase in the demand for educated labor by the government, for instance, could drive wages up in the private sector. In turn, this may translate into higher prices and lower output. Similarly, higher wages on new hires in the public sector could have an adverse “signaling effect” on wages in the private sector. Thus, higher public investment could generate negative externalities, which could mitigate the positive supply-side effects accounted for in SPAHD macro models.

Finally, it should also be noted that our methodology may involve some element of “double counting” when it comes to evaluating maintenance spending. Indeed, SPAHD models calculate maintenance requirements endogenously, by 10
relating them to depreciation of physical capital (see equation (6)). Thus, any new investment, whether in infrastructure, health, or education, to the extent that it translates into an increase in the corresponding capital stock, will automatically generate an estimate of maintenance outlays. A legitimate question, therefore, is whether a PIP estimate of maintenance outlays is at all needed. However, it is important to keep in mind that the estimate produced by the SPAHD model can be viewed as corresponding strictly to the expenditure needed to avoid physical depreciation of public assets. Assuming that the (average) depreciation rates included in the SPAHD framework are accurate estimates, this would require setting θM = 1 in equation (6). The maintenance expenditure accounted for in the PIP could therefore be viewed as corresponding mostly to the other outlays associated with the delivery of maintenance activities, such as the cost of running a maintenance agency (excluding salaries and other compensation). In practice, these expenses could be very difficult to separate from the category “other spending on goods and services” identified in the PIP, so that some “double counting” may be inevitable.

# **3.  Link with a Medium-Term Budget**

It is apparent from the foregoing discussion that implementing the above methodology can produce a complete set of fiscal accounts, including a Medium term Budget Framework (MTBF) as long as PIP estimates are available for several years. This is important, given that several observers (including donors) have emphasized that elaborating more advanced Medium-term _expenditure_ frameworks is a key priority for strengthening the PRSP process (see, for instance, German Development Cooperation (2005)). The foregoing approach goes a step further by providing a complete medium-term budget, with simultaneous determination of aid requirements.

In summary, the methodology proposed in this paper for linking PIPs and SPAHD macro models can be summarized as follows: 11
**Step 1** . Establish the public investment program from the “bottom up”, and provide estimates at constant prices (that is, at prices of the base period t = 1) of _a_ ) investment in health, education and infrastructure; _b_ ) maintenance needs associated with these new investments; _c_ ) other spending on goods and services; _d_ ) wages and salaries; and e) estimate user charges that would accrue directly to the budget, for periods t = 1,..., T.

**Step 2** .  Incorporate estimates of investment, maintenance and user charges in the model; given assumptions for the path of domestic and foreign borrowing, solve the model for aid requirements for periods t = 1,..., T.

**Step 3** . If aid requirements are deemed feasible (in the sense of representing a realistic basis for discussion with donors), go to the next step. If not, go back to step 1 and revise (downward) spending estimates contained in the public investment program.

**Step 4** . Calculate the medium-term budget  for t = 1,..., T, with aid requirements shown as residual. Repeat steps 1 to 3, If necessary, with alternative assumptions about domestic and external financing.

# **III.  Applications**

To illustrate the functioning of the framework described in the previous section, we apply it to Niger, using the SPAHD framework developed by Pinto Moreira and Bayraktar (2005). With 63 percent of the population living below the poverty line, and 34 percent considered as extremely poor, Niger is the second poorest country on earth. Despite recent improvements, social indicators remain abysmal, and among the weakest in the world. Infrastructure indicators are also poor, as in the rest of Sub-Saharan Africa. Various observers have taken the 12
view that to stimulate growth and improve human indicators, a large increase in public investment is needed.

We begin by describing an illustrative PIP for Niger. We then determined the implied aid requirements. We conclude with an examination of the impact of alternative assumptions of tax effort on these requirements.

# **1.  An Illustrative Public Investment Program, 2006-15**

Table 1 shows an illustrative PIP for Niger, with all flows measured at constant 2004 prices. In the table, public investment includes not only the three categories identified earlier (education, health, and infrastructure) but also a category “other”, which represents a relatively small share of total capital outlays. In a typical SPAHD application, this component is generally treated as a flow only, with no impact on the stock of public assets.

The 2005 values of the capital expenditure series are taken from the baseline table estimated by Pinto Moreira and Bayraktar (2005). The growth rate of public investment in infrastructure is assumed to increase gradually from 3 percent in 2006 to 6 percent in 2009, and to remain at that level up to 2015. Regarding maintenance expenditures in infrastructure, user charges, and wages and salaries, we assume that they represent 5 percent of investment in infrastructure. Other spending on goods and services is assumed to account for one percent of capital outlays in infrastructure.

The growth rate of public investment in education is assumed to grow at the lower rate of 2 percent in 2006, 3 percent in 2007, and 4 percent from 2008 to 2015. While maintenance expenditures in education, user fees, and other spending on goods and services are equal to 1 percent of capital expenditures in education, wages and salaries are taken as 5 percent of this component of investment.

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The growth rate of public investment in health is taken to be equal to the growth rate of investment in infrastructure. Similarly, the shares of maintenance expenditures in health, user fees, other spending on goods and services, and wages and salaries are assumed to be equal to the corresponding shares in investment in education. Finally, the growth rate of other public investment is assumed to be equal to a constant value of 1 percent throughout the simulation period. For this component, whereas the shares of maintenance expenditures and user fees is taken to be zero, the shares of other spending on goods and services, and wages and salaries are set at 1 percent of investment.

Total public capital expenditure data are obtained by adding up the components of capital expenditures. As shown in Table 1, investment in infrastructure represent about two-thirds of total investment, investment in education about 10 percent of that total, and investment in health about 18 percent. In proportion of GDP (as shown in the bottom part of Table 2), public investment represents about 5 percent in the base period.

# **2.  Aid Requirements and the Medium-Term Budget Framework**

We now turn to a calculation of aid requirements using the methodology described earlier and the SPAHD framework for Niger described by Pinto Moreira and Bayraktar (2005).<sup>6</sup> To project exogenous variables, we follow the assumptions underlying the experiments in that paper. These involve, for instance, setting the rate of growth of export and import prices to the same value, imposing an effective interest on foreign borrowing of 0.5 percent per annum. Domestic borrowing is kept at 1 percent of GDP (the value observed in the base period) and foreign (concessional borrowing is limited to 2 percent of GDP). Tax rates that are exogenous are also kept constant initially.

> 6The paper also provides details about parameter estimates and the calibration process.

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We also assume that public investment is only partially efficient, in the sense that capital outlays in education, infrastructure, and health do not serve to increase one to one the public capital stock. Specifically, we assume that only half of investment flows turn into increases in public capital and impose αh = 0.5 for all h in equation (10). This is consistent with Pritchett’s (1996) estimate that half of all capital outlays are wasted in developing countries. It also corresponds to the mid-point of the range of values estimated by Arestoff and Hurlin (2005). Although this choice has no effect on the calculations of aid requirements (which are based on the _flow_ data provided by the PIP), they do affect macroeconomic outcomes, namely, the economy’s growth rate and the MDGs.<sup>7</sup> Table 2 shows the aid requirements calculated by the model and the associated medium-term budget framework for the period 2006-15. The results show that with (domestic and foreign) borrowing constant as a share of GDP, and a more or less constant tax effort (of about 10 percent of GDP), expenditure of about 25 percent of GDP, aid requirements drop slightly over time from 12.5 percent in 2006 to 11.4 in 2015. In proportion of tax revenues, aid falls from 125 percent in 2006 to 109 in 2015, but in proportion of total public investment, aid rises from about 241 to 250 percent during the same period.

The impact of the PIP-cum-aid package on the MDGs is shown in Table 3. The headcount index decreases in the “best” case (a consumption growth elasticity of -1.5) from about 63 percent in 2006 to 38.5 percent in 2015. However, with a consumption growth elasticity of -0.5, the poverty rate drops by less than 10 percentage points over the same period. The literacy rate (defined as the ratio of educated labor to total population) increases from 20.3 percent in 2006 to 27 in 2015, as a result of an increase in public investment in education and infrastructure combined with an increasing number of teachers. Whereas infant mortality drops from 150 in 2006 to 118 in 2015, malnutrition prevalence

> 7Of course, experiments involving a higher efficiency assumption parameter (perhaps as a result of reforms aimed at improving governance) could also be performed.

15
drops from 40.6 to 36 percent during the same period. In the model, these improvements are a result of a combination of factors—reduction in poverty, increased public investment in health, and higher GDP and private consumption per capita.<sup>8</sup> For similar reasons, life expectancy also increases (albeit slightly), from 46.9 in 2006 to 49.5 in 2015. The percentage of population with access to safe water rises from 58.1 percent in 2006 to 61.4 percent in 2015 as a result of increasing public investment in infrastructure.

In sum, the projections show that MDG indicators improve quite sensibly in Niger; the composite MDG index (which is defined as a geometric average with base 2005 = 100 for convenience) shows a significant overall improvement, increasing by 20.1 percentage points. But despite these improvements, and given the illustrative PIP considered here and other assumptions about the environment that Niger is likely to face in the coming years, the MDG of halving poverty and malnutrition would not be achieved by 2015. Everything else equal, a more ambitious program of public investment would be required—possibly leading to absorption problems.

# **3.  Tax Reform and Aid Requirements**

The foregoing analysis was based on the assumption that the exogenous effective direct tax rate (which is assumed to be under the control of the authorities) in the SPAHD model was kept constant at its base period value.<sup>9</sup> Thus, tax effort, as measured by the ratio of the associated revenues to GDP was taken to be constant.

To highlight the link between the calculation of aid requirements and tax policy, we consider an alternative scenario. Specifically, we assume that the direct “effective” tax rate, which amounted to 1.9 percent of GDP in 2004, is

> 8The elasticity used to link poverty and the MDGs corresponds to the “neutral” case of unity. Adjusting this parameter is of course straightforward.

> 9The effective indirect tax rate was assumed to be endogenously determined, as in the original model (see Pinto Moreira and Bayraktar (2005)).

16
gradually increased, by one percentage point per annum beginning in 2007 for 5 years. Thus, the direct tax rate rises gradually to 6.9 percent of GDP in 2011. While this exercise is, again, for purely illustrative in nature, it is a sensible policy to consider in the case of Niger, where tax revenue ratios are relatively low compared to other countries at a similar level of per capita income.

The results of this experiment are illustrated in Tables 4 and 5. As shown in Table 4, the revenue-to-GDP ratio rises gradually over time, from about 10 percent to about 16 percent now. With the expenditure and borrowing ratios remaining practically the same, the implication is a significant drop over time in aid requirements, from 12.5 percent in 2006 to 7.9 percent in 2010 and 6.6 percent in 2015. As a proportion of tax revenues, aid requirements drop considerably, from 124.8 percent in 2006 to 41.6 percent in 2015 (compared to a drop to 109 percent with a constant direct tax rate). As a proportion of total public investment, they also drop quite dramatically, from 241 to 137 percent during the same period (compared to an increase to 250 percent in the previous scenario). However, in terms of the MDGs, the impact is much less significant; poverty, in the neutral elasticity case drops now from 63 percent to 50.3 percent (compared to 45.5 percent in the previous case) between 2006 and 2015, whereas the composite indicator improves from 102 in 2006 to 118 in 2006 (compared to 122 previously). The reason, of course, is that the increase in the direct tax rate lowers disposable income, which in turn slows the growth rate of private consumption. As a result, the fall in poverty is less significant, and other human indicators improve by less as well. Put differently, reducing aid dependency over time through domestic tax reform entails a cost, in terms of the speed at which the MDGs can be achieved—even though a significant portion of the increase in domestic resources is used to finance productive spending.

Of course, this apparent trade-off between increasing the share of government spending financed through domestic resources and poverty results from the fact that, because there is only one category of households in the 17
model, the increase in the tax rate is implicitly assumed to affect equally all households in the economy. In practice, low-income households would be largely exempt from direct taxation; their consumption pattern would not be affected, implying that the overall effect of higher taxes may well be a lower poverty rate (relative to the case considered here).

At the same time, however, upper-income households may be more inclined (or capable) to evade tax payments following an increase in the direct tax rate, thereby reducing (marginal) revenues from the tax. As a result, public investment may be lower than otherwise, which may dampen growth as well as the increase in disposable income and consumption expenditure. The net effect on poverty may therefore be ambiguous. These considerations are worth bearing in mind when designing “scaling down” scenarios, following a period of sustained increases in foreign assistance.

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# **IV.  Conclusions**

The purpose of this paper was to develop a “bottom up” approach to linking public investment programs with a class of macro models recently developed to quantify Strategy Papers for Human Development (SPAHD) in lowincome countries. This class of models, developed by Agénor, Bayraktar and El Aynaoui (2006) and extended by Pinto Moreira and Bayraktar (2005) and Agénor, Bayraktar, Pinto Moreira, and El Aynaoui (2005), provides a tractable framework for accounting for the links between aid, public capital (diaggregated between education, health, and infrastructure), and the supply side. By linking the model through cross-country regressions to indicators of poverty, malnutrition, infant mortality, life expectancy, and access to safe water, we obtain a consistent framework for evaluating the impact of policy decisions on the Millennium Development Goals.

The methodology proposed in the paper involves establishing constantprice projections of investment outlays (disaggregated into infrastructure, education, and health), spending on maintenance and other goods and services, salaries, and user charges. These estimates are then incorporated in the SPAHD macro framework to calculate, under alternative scenarios regarding domestic financing and foreign borrowing, aid requirements. The impact on growth and indicators associated with the Millennium Development Goals were also calculated. Illustrative applications, based on a SPAHD model for Niger, were used to highlight the impact of tax reform on aid requirements.

The “bottom up” approach proposed in this paper needs assurance about the quality and productivity of public investment. This would require building up the institutions and capacity to conduct objective cost-benefit analyses of proposed investment projects, to structure contracts and evaluate bids, and to monitor the implementation of public investment projects. This may also involve 19
the compilation and reporting of improved data, including estimates of the public capital stock and its depreciation rate.

An issue that needs to be further explored in the context of our proposed approach is the treatment of contingent liabilities, which may be sizable if some investments involve private participation. Although this may be an issue of limited importance for the low-income countries that we have in mind, in general excessive commitments can create problems. In principle, actual and potential costs for the government implied by a private-public partnership (PPP) contract should be taken into account when calculating aid requirements. Indeed the net present value of scheduled government payments under PPP contracts, less any contractual receipts such as concession fees—both discounted using a risk-free interest rate—should be counted as a liability and added to the initial stock of government debt.<sup>10</sup> Our methodology implies that, through their effect on debt servicing, these commitments would affect the calculation of aid requirements.<sup>11</sup> At the same time, however, it should be borne in mind that adequate estimates of contingent liabilities are difficult to establish.

> 10 More precisely, it is the _expected_ liability— that is, the stock of guarantees weighted by the probability that they will materialize—that should be added to the public debt.

> 11Alternatively, they would require the generation of larger future primary surpluses (or smaller primary deficits to ensure debt sustainability.

20