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The purpose of this paper is to examine the relationship between foreign aid and income inequality (IIQ) reduction for 16 African countries using unbalanced panel data covering the period 1990–2011. This paper attempts to answer the critical question: does foreign aid lead to IIQ reduction?

To examine the effect of foreign aid on IIQ, this paper uses an RE model with robust OLS regression and system-GMM estimator, which are useful in dealing with the endogeneity problems.

Results of RE model indicate that foreign aid, foreign direct investment, trade openness as well as corruption have a positive and statistically significant effect on IIQ. Government spending and inflation have a negative and statistically significant effect on IIQ, while GDP per capita growth has a negative but statistically insignificant relationship with IIQ. The results are robust by using system-GMM dynamic panel model which confirms that the coefficients of all considered variables remain same sign and significance.

This study implies that an increase in foreign aid is associated with an increase in IIQ. As an effective strategy to foreign aid, this paper suggests that improving of financial sector development, and institutional quality and policies can reduce income inequalities and stimulate economic growth.

This paper is the first of its kind to empirically explore the relationship between IIQ and foreign aid measured here by net aid transfers as a share of GDP in African countries, using modern econometric techniques, time period and a variety of control variables.