Keeping a Close Eye on Local Governments’ Finances Can Improve How they Govern 

By Roberta Kwok

The federal government gets more attention, but local governments in the United States have a direct effect on numerous aspects of people’s daily lives, including education, safety, and transportation. And their budgets comprise a hefty chunk of the U.S. economy, accounting for 23% of government resources and 8% of GDP. Yet researchers know surprisingly little about the best way to promote effective management of towns and cities.

“I discovered at some point that we don’t have a lot of empirical evidence about potential municipal governance mechanisms,” says Anya Nakhmurina, an assistant professor of accounting at Yale SOM. “It was just shocking to me.”

In a recent study, Nakhmurina filled this gap by investigating whether monitoring by state can serve as a municipal governance mechanism. Specifically, she studied the effects of fiscal monitoring policies, which require a state office to review annual financial reports submitted by local governments. She found that these programs appeared to make towns and cities issue annual financial reports more quickly and improved their fiscal health. Corruption convictions of municipal officials also fell, suggesting that local leaders were on better behavior.

“Incentives matter,” Nakhmurina says. “Monitoring is a powerful tool that can lead to real changes.”

Read the study: “Does Fiscal Monitoring Make Better Governments? Evidence from US Municipalities”

In the past, researchers have done plenty of work studying the effectiveness of various incentives and monitoring schemes at corporations. They have found a number of mechanisms by which managers are encouraged to act in shareholders’ interests and to do a better job of governing the firm—for example, monitoring by directors, managerial compensation plans, internal and external labor markets, and the market for corporate control—that is, the possibility of a takeover of a publicly traded company.

But the mechanisms that work to promote effective governance in a corporation may not work in a municipality, a fundamentally different setting. For example, there are no shareholders in a municipal setting; instead, the primary beneficiary of the governmental services is the citizenry. And without the overarching framework of shareholder value maximization, it’s a challenge to find systematic ways to measure performance by city governments.

Why start research on municipal governance by examining state monitoring? The short answer, Nakhmurina says, is that states have both an incentive to monitor and the appropriate accounting expertise to do so. While constituents are the primary consumers of municipal services and fund them through taxes, they aren’t likely to act as monitors of city governance practices—few have the knowledge and inclination to wade through complex governmental accounting reports. States, on the other hand, worry about the fiscal health of their municipalities and have the staff to track it in the state auditor’s office.

To ask whether state monitoring works to improve governance in a municipal setting, Nakhmurina took advantage of the fact that 23 U.S. states perform fiscal monitoring of local governments, and 10 of them had started doing so between 2009 and 2017. These programs were intended to help state auditors detect financial problems.

While towns and cities had always produced financial reports, and in some cases had submitted them to the state, the statements had received little attention in the past, Nakhmurina says. When the fiscal monitoring policies were introduced, someone might have “actually started looking at these financial reports,” she says.

Because the state fiscal monitoring policies were adopted at different points in time, Nakhmurina was able to measure how increased monitoring affected municipal behavior without worrying about economic trends or any other concurrent but unrelated effects. To analyze the effect of these programs, Nakhmurina obtained data on municipal reports and financial details from sources such as the Electronic Municipal Market Access portal and the Atlas Municipal database.

First, she assessed whether monitored towns produced their reports more quickly. The answer was yes: The amount of time between the end of the fiscal year and report filing dropped by 41 days. And the reports’ quality seemed to improve too. For example, the likelihood that an auditor would find a material weakness in the report or require a restatement decreased by 7 and 16 percentage points, respectively.

Nakhmurina wondered if these improvements were reflected in the fiscal health of municipalities. To find out, she evaluated indicators of fiscal health such as ability to pay short-term bills, funds for financial emergencies, and reliance on debt. She found improvements on many of these measures following the start of fiscal monitoring.

The results raised the possibility that local officials had become more educated about financial reporting. And perhaps they noticed potential problems in their towns or cities sooner.

Why had this happened? One possibility was that local officials learned more about the state of their towns and became more competent at assessing fiscal health. For example, a state auditor may have alerted them to a financial issue and educated them how to detect the issue using information from their accounting report.

The second possibility was that local officials had been corrupt, and once the fiscal monitoring started, they cleaned up their act.

To investigate the second channel, Nakhmurina looked at the number of times local officials had been convicted of corruption at each U.S. Attorney’s office. Indeed, she found that fiscal monitoring was associated with a 23% decrease in convictions per office per year.

Another channel of accountability in government is elections. Nakhmurina checked whether having faster access to information about local governments made a difference in elections, and found that fiscal monitoring decreased the likelihood of an incumbent getting re-elected by 8%. “It looks like this information is somehow being disseminated to the citizens,” she says. For instance, perhaps journalists are reading the reports and publishing evidence of incompetence. Alternatively, if incumbents were corrupt, perhaps they put less effort into being reelected. With the increased monitoring, they couldn’t continue their shady behavior in office as easily, so they didn’t care as much about winning another term.

It’s too early to say whether all states should adopt fiscal monitoring, Nakhmurina cautions. “We’re just scratching the surface,” she says. Researchers have a solid understanding of which incentives are effective in the corporate world. For municipal governance, she says, “it would be hard to blindly recommend this policy to everybody without truly understanding what else works and doesn’t work.”