Global Flow of Foreign Aid and Change in Recipients’ Local Labor Institutions

Abstract

How does foreign aid affect recipient countries’ labor institutions? Extant empirical evidence is sparse due to ambiguous theoretical predictions and potential endogeneity issues. This study uses data detailing aid flow and institutional functions to mitigate such inconclusiveness and displays originality by constructing a concise theoretical framework in which foreign aid contributes to the improvement of the labor institutions in recipient countries through two mechanisms—economic growth purpose and expected aid attraction. The findings indicate that only aid to enhance local economic growth provides incentives to change domestic labor markets. Such effects have a more crucial influence on labor institutions of minimum wage, collective bargaining rights, and working hours than those related to hiring and firing regulations, mandated costs for worker dismissal, and conscription. For comparison with the actual aid level, we construct forecasted proxies to capture exogenous fluctuations in aid, determining that domestic labor markets can also change via a novel mechanism, as the recipient voluntarily mimics the funder’s labor policies in anticipation of receiving future aid, with exact amounts derived from the noninstitutional characteristics of pairs of bilateral recipient and giver economies. Therefore, we provide policy implications for the aid giver on how to secure a continued and increased aid flow and for the aid receivers on which aspects of reforming measures are most effective in enhancing the labor market regulations.