International Journal of Economics and Finance; Vol. 5, No. 9; 2013 ISSN 1916-971XE-ISSN 1916-9728 Published by Canadian Center of Science and Education 117 Sectoral Foreign Aid and Income Inequality Ruhaida Saidon 1 , Zulkornain Yusop 2 , Normaz Wana Ismail 2 & Law Siong Hook 2 1 School of Economics, Finance & Banking, College of Business, Universiti Utara Malaysia, Malaysia 2 Department of Economics, Faculty of Economics and Management, Universiti Putra Malaysia, Malaysia Correspondence: RuhaidaSaidon, School of Economics, Finance & Banking, College of Business, Universiti Utara Malaysia, 06010 Sintok Kedah, Malaysia. Tel: 60-4-928-3623. E-mail: ruhaida78@gmail.com Received: August 5, 2012 Accepted: July 31, 2013 Online Published: August 26, 2013 doi:10.5539/ijef.v5n9p117 URL: http://dx.doi.org/10.5539/ijef.v5n9p117 Abstract This study contributes to the empirical understanding of foreign aid and income inequality by investigating the effect of foreign aid on income inequality in recipient countries, based on the disaggregation of foreign aid figures. For this purpose we include four main sectoral foreign aid (social sector, economic sector, production sector and multi sector) as determinants of income inequality. This study utilized the Generalized Method of Moments (GMM) method for a panel of 75 foreign aid recipient countries covering the period of 1995-2009. The results indicated that different sectoral foreign aid affected income inequality differently. Aid to economic sector has significant impact in reducing income inequality. In contrast, aid to multi sector significantly increased income inequality. Keywords: foreign aid, income inequality, GMM 1. Introduction Over the past decade, foreign aid has been regarded as an important tool in fighting poverty in less developed and developing countries. Foreign aid or known as official development assistance (ODA) can be define as a flow or transfer of payment including a grant element made by official agencies, state and local governments, or by their executive agencies for developing countries and multilateral institutions. The main objective of giving foreign aid is to develop economic and welfare development in poor and developing countries. Foreign aid is believed enable to address the poverty and income inequality problem by facilitating faster and sustained economic growth in these countries. Poor countries are facing scarce of capital for saving and investments in order to generate income and economic growth. According to Nelson (1956), Erikson (2005) and Sachs et al. (2005), poor countries have low incomes and savings which leave them in a “vicious circle of poverty” or “poverty trap”. In other words, they experience a “low-level equilibrium trap” where higher income does not lead to increase saving but only results in higher population growth. The earlier study on the role of foreign aid on economic growth was undertaken by Chenery and Strout (1966) using “two-gap” model. In this model, they assumed that foreign aid filling the financing gap and trade balance gap simultaneously. The financing gap means that a country has insufficient resources for investments. While trade balance gap is the gap between import requirement for a targeted level of production and foreign-exchange earnings, which implies that a country possesses insufficient foreign currency to pay for imports. Perhaps foreign aid will dissolve the “vicious circle of poverty” and connects less developed countries to the virtuous circle of productivity and growth. Then inceased in growth will improve the standard of living of the poor countries. However, after fifty years, the role of foreign aid in fostering economic growth and development in poor countries continues to be a subject of debate among policy makers and researchers. These arguments were supported by the voluminous of empirical literatures which indicated little evidence that foreign aid promoted economic growth. For instances, Cassen (1994), Papanek (1973), Mosley (1980), Mosley et al. (1987) and Boone (1994) found inconclusive result between aid and growth. In contrast, Burnside and Dollar (2000) found positive impact of aid on growth conditional with good fiscal, monetary and trade policies of the recipient countries. However, Easterly (2003) finds that foreign aid is no longer effective in countries with good economic policies in different time, country and sample size. Despite the lack of robust positive correlation between aid and growth, the economists and policy makers shift to focus on the direct impact of foreign aid on poverty and income inequality in recipient countries. Among the