Sectoral Foreign Aid and Income Inequality in Nepal

Objective: The objective of this paper is to analyze the impact of foreign aid on income inequality in Nepal with disaggregation of foreign aid into four major sectors: social sector, economic sector, production sector, and multi-sector. Methodology: This study uses time-series annual data over the period 2002-2023. The autoregressive distributed lag; bound test and error correction model are applied to find short-run and long-run impact. Result: The bounds test for cointegration, confirms that there is no long-run relationship between the dependent variable and the set of covariates in all regressions. The short-term dynamics results indicate that aggregated foreign aid has a negative and statistically significant impact on income inequality in Nepal. When foreign aid is disaggregated by sector, its impact varies. Aid directed toward the social sector and multi-sector initiatives appears to reduce income inequality, whereas aid to the economic and production sectors shows a weaker and inconsistent effect on inequality. Conclusion: Social and multi-sector aid effectively reduces inequality by directing funds to health, education, social services, and environmental protection projects benefiting low-income populations. Conversely, economic and production sector aid often supports urban projects, reaching fewer marginalized communities. Policymakers should prioritize social programs and adapt economic aid to promote inclusive growth, such as rural infrastructure and small enterprise support, to improve equity. Also, Nepal should adopt policies that prioritize sustainable and inclusive development to strengthen the long-term relationship between aid and inequality.