governments consider a priority. The cost to this a reduction in the local provision of other locally needed services. For example, in many Latin American countries, decentralization has entailed earmarking substantial parts of intergovernmental transfers to localities for local infrastructure investment. Although not fully effective (since money is fungible, there is usually some substitution of transfers for own-source revenues) the result has usually been the expansion of capital spending, while making the already difficult problem of funding the operation and maintenance of these investments, even more difficult.

<u>Source: Ter-Minassian 1997 and Oates 1999.</u>

**_2.1.3. Local Borrowing:_** Currently, the number of developing countries that have efficient markets for local borrowing is still limited. As markets evolve though, borrowing becomes a more viable source of funding, especially for the urban and more developed local governments. Local credit systems are advantageous, because they make available revenue for infrastructure projects and for alleviating the spending responsibility that decentralization places on local governments. However, wide use may interfere with building effective and accountable state-citizen relations. This is mainly because the citizens who receive benefits may not be the same ones who are responsible for paying them back.

In principle, because of intergenerational equity considerations, it makes sense to finance long-lived investment projects with borrowings to spread out the costs of projects among future beneficiaries (Burki et al. 1999).<sup>12</sup> In order to make sure that local governments use credits for financing capital outlays, subnational credit systems commonly establish a “golden rule” that prohibits using credits to pay current budget deficits. However, because resources are fungible and monitoring of capital projects is often inadequate, it is not always possible to ensure that funds nominally borrowed for capital purposes don’t finance other expenditures (Peterson, 2000). Thus, when borrowing is used to cover current account deficits, it has the opposite intergenerational effects, and the costs of services enjoyed by today's tax-payers shifts to future generations.

An additional risk with borrowing is that local governments will finance a variety of projects, exhausting their credit capacity and leaving the political pain of debt service to their successors. For these reasons, the use of credit scores low in building effective local state-citizen relationships. However, citizen participation in the establishment of debt levels and in the use of the credits can be an efficient instrument to reduce risks, and may even contribute to the enhancement of state-citizen interactions. In Nicaragua, for example, local governments can only contract debt to a maximum level of 20 percent from budgeted revenues. When credits go beyond a specific term in office, or over the 20 percent ceiling, local governments must submit their borrowing plans to public consultations (Pineda 2003). In these cases, local borrowing may shift to the left of the continuum of Figure 2, denoting a higher level of local accountability.

**_2.1.4. Aid_ :** Aid is an additional source of local revenue, but it is not commonly taken into account by studies of fiscal decentralization and local governance. In many cases it amounts to a substantial proportion of local revenues, but since aid is commonly allocated off-budget,

> 12 In a typical private-sector infrastructure project, only 20 percent or less of investment funds are raised by equity, the rest of the financing comes from credit.

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