Moral hazard and the composition of transfers: theory and evidence from cross-border transfers

We study how a donor can use restricted transfers to control the moral hazard behavior of a recipient and how the composition of unrestricted and restricted transfers is adjusted in response to changes in the moral hazard behavior of the recipient. Under certain conditions, our game-theoretic model predicts that the donor reduces the proportion of restricted transfers in total transfers as the moral hazard behavior of the recipient declines. Using foreign aid transfers (i.e., project aid and program aid) and panel data covering the period 1991–2007, we find econometric support for the prediction of the model. Our results suggest that some variables that affect the size of foreign aid may have no effect on the composition of aid.