# **5. Which model to recommend for infrastructure sectors in developing countries?**

In developing countries, there are at least two key considerations that policy makers may want to take into account when designing institutional arrangements for the ownership function. First, the optimal volume of infrastructure investment cannot be assessed separately from the other general objectives, in light of the presence of a limited fiscal space. Second, the fiscal impact of the myriad explicit and implicit forms of subsidies may require close oversight and monitoring. Let us review in t urn the existing literature in both areas.

The core of the fiscal space debate is about the importance of the design of macroeconomic fiscal adjustment programs for the level of investment in infrastructure. Fiscal rules adopted to ensure debt sustainability as part of standard IMF macroeconomic adjustment programs are increasingly being criticized as excessively binding constraints. Moreover, there is widespread concern that these rules may permanently reduce the public sector’s contribution to capital accumulation, particularly in infrastructure. Whereas this debate has been quite intense in Europe as part of the assessment of the Stability Pact (see Buiter and Graf, 2004 for a comprehensive overview), it is relatively new in developing countries.

Despite the relevance of the design of a financing mechanism and the ownership and monitoring regime for SOEs, there is little new theoretical infrastructure‐specific literature on these topics. In what follows, we will summarize the key lessons coming from the theoretical modeling of the different ownership arrangements, based on the framework developed by Vagliasindi (2007), once we account for the presence of binding budget constraints and introduce in the analysis the cost of public funds. The underlying idea behind the cost of public funds is simple: in practice each dollar spent by the government is raised through distortionary taxes and its cost to society equals the dollar spent plus the shadow cost of raising public funds.

Let us rely on the theoretical goal of social welfare maximization in order to analyze the conditions under which different SOE governance arrangements can suit developing countries, taking into account the presence of a limited fiscal space. In a simple setting we have a unique shadow cost of public fund, equal for any single tax yield and any public firm revenue coming from the solution of the social welfare maximization problem. In practice, under different governance arrangements the nature and the level of the cost of public funds may be different. Under a centralized ownership function, the cost of public fund is given by economy wide tax data and is independent from the financing issues of the infrastructure sector under consideration, as long as the latter is small relative to the economy. Under a decentralized ownership function, the shadow cost of public fund is only dependent of the financing issues restricted to the infrastructure sector, excluding the distortionary effects that this provokes to the other sectors in the economy. The divergence between the costs of public funds can be determined by several factors, such as the absence of a sufficient level of transfers from the public budget to cover costs. Different governance models are also associated with different tariff levels, as well as different quality enhancing and cost reduction activities. Higher levels of mark‐ up (and distortion) are associated with decreasing deficits (transfers) to the firm budget. This in turn i mplies higher price mark up and lower cost reduction and quality enhancing activities.

From a purely theoretical perspective it is difficult to provide strong guidance for the preference of one of the governance model against the others. If the policy makers are mainly concerned with allocative efficiency, the governance model which minimizes distortionary costs is the centralized one where the Ministry of Finance exercises the ownership function for the overall 12