The Political Economy of Multilateral Aid Funds

When allocating foreign aid, donor countries face a problem of incentivizing recipient countries to invest in state capacity. Here, we show that donors can incentivize recipient countries by committing to collective decision-making: If aid allocation decisions are made ex post via bargaining between donors, then the negotiated outcome will be skewed towards aggregate efficiency, which induces the recipients to compete over ex ante investments. Our model links the fund's composition of membership and its decision rules to participation, investment and allocation decisions. We also find that majority rule induces stronger competition between recipients, resulting in higher investments in state capacity. The qualitative predictions of our model are broadly consistent with empirical findings on multilateral aid. In particular, the model rationalizes our novel empirical finding that, relative to organizations that use a consensus rule, organizations that use majority are more responsive to changes in recipient-country quality.