Sub-national borrowing incentives under the principal-agent model in the Bolivian decentralization experience

Decentralization traditionally derives its rationale from the theory of 'fiscal federalism (Tiebout model, 1956) that emphasizes the benefits arising from governments functioning at lower levels, increasing allocative efficiency and responsiveness of government, trough clear assignment of functions, informed decision-making, definition of local priorities and focus on accountability. Experience however, shows that decentralization also has costs and some times these can outweigh the potential benefits. For instance, externalities between jurisdictions e.g. arising from tax competition, tax exporting and opportunistic behaviour of lower level governments, if allowed to go uncorrected, may inhibit growth. One manifestation of such externalities is the existence of soft budget constraint for the local governments (LGs), leading to' fiscal indiscipline and negative borrowing incentives and their implications for economic stability and growth (Qian and Roland, 1998).