Debt issuance incentives and creative accounting: Evidence from municipal mergers in Japan

Creative accounting has been a considerable problem in the field of governance and has caused serious economic issues. However, how governments determine the scale of creative accounting is unknown in the existing literature.

We study whether a difference in the usage and the scale of creative accounting is determined by the intensity of the incentive to issue excessive debt. To study this, we focus on municipal mergers, a well-known setting wherein smaller merging municipalities have a stronger incentive to enjoy freeriding and issue debt since the debt burden will be shared and mainly owed by larger merging municipalities. This setting enables us to use the relative population size as a continuous treatment representing the strength of debt issuance incentives, whereas existing papers focused on binary treatments. Utilizing the data of Japanese municipal mergers, we find that governments with small relative populations, which have a strong debt issuance incentive, employed creative accounting more intensively than others. Moreover, we investigate how governments used the money obscured through creative accounting for the first time and find that it was not used to overcome financial difficulties nor increase politicians’ pecuniary gains but to increase resident welfare.