OSIPP Discussion Paper : DP-2018-E-012

Creative Accounting and Municipal Mergers*-A Theoretical and Empirical ApproachOctober 16, 2018
Tsuyoshi Goto†
Research Fellow of Japan Society for the Promotion of Science
PhD. Student, Graduate School of Economics, Osaka University

Genki Yamamoto
Master’s Student, Graduate School of Economics, Osaka University【Keywords】Creative accounting; Municipal merger; Fiscal common pool problem;
Regulation for borrowing【JEL Classification】H74; H81; H83【 Abstract 】 This study investigates what causes governments to use creative
accounting. It is difficult to grasp the mechanism of creative accounting and show its
existence. This is because, although creative accounting is seemingly closely tied withincreases in debt, whether creative accounting is a cause or result of the debt increase isambiguous and finding the occurrence of creative accounting is not easy. However, by
focusing on municipal mergers in Japan in the 2000s, we clarify that the incentive toincrease debt causes the use of creative accounting and show the existence of creative
accounting, theoretically and empirically. Our theoretical model shows that agovernment with a stronger incentive to increase debt rationally employs creative
accounting more fiercely and that an improvement in fiscal transparency reduces boththe use of creative accounting and the deficit amount. Corresponding to this finding, byusing a difference-in-difference analysis and data on Japanese municipal mergers, weshow that municipalities with a stronger incentive to increase debt tend to employ
creative accounting.
* We are thankful to our previous co-author Mika Kanda for her extraordinary support and our supervisor Nobuo
Akai for his help in our study. We greatly appreciate Åsa Hansson, Daiki Kishishita, Eva Mörk, Gareth Myles,
Haruaki Hirota, Hideo Yunoue, Hitoshi Saito, Jan-Egbert Sturm, Katsuyoshi Nakazawa, Keigo Kameda, Koichi
Fukumura, Takahiro Watanabe, and Yukihiro Nishimura for their valuable comments and suggestions. We also
thank Takashi Kuramoto and the participants of the Akai Seminar at Osaka University and Kansai public
economics workshop for their comments and the Cross Boundary Innovation Program of Osaka University, JSPS
KAKENHI Grant Number JP18J12301, and the DENTSU scholarship foundation for financial support. The
authors are responsible for any remaining errors.
†Corresponding author. Email:sge010gt@student.econ.osaka-u.ac.jp

Creative Accounting and Municipal Mergers-A Theoretical and Empirical Approach-∗Tsuyoshi GOTO†, Genki YAMAMOTO‡
October 16, 2018

Abstract
This study investigates what causes governments to use creative accounting. It is diﬃcult to grasp
the mechanism of creative accounting and show its existence. This is because, although creative
accounting is seemingly closely tied with increases in debt, whether creative accounting is a cause
or result of the debt increase is ambiguous and finding the occurrence of creative accounting is
not easy. However, by focusing on municipal mergers in Japan in the 2000s, we clarify that the
incentive to increase debt causes the use of creative accounting and show the existence of creative
accounting, theoretically and empirically. Our theoretical model shows that a government with astronger incentive to increase debt rationally employs creative accounting more fiercely and thatan improvement in fiscal transparency reduces both the use of creative accounting and the deficit
amount. Corresponding to this finding, by using a diﬀerence-in-diﬀerence analysis and data on
Japanese municipal mergers, we show that municipalities with a stronger incentive to increase debt
tend to employ creative accounting.
KeywordsCreative accounting; Municipal merger; Fiscal common pool problem; Regulation forborrowing
JEL Classification: H74; H81; H83∗ We are thankful to our previous co-author Mika Kanda for her extraordinary support and our supervisor Nobuo Akai

for his help in our study. We greatly appreciate Åsa Hansson, Daiki Kishishita, Eva Mörk, Gareth Myles, Haruaki
Hirota, Hideo Yunoue, Hitoshi Saito, Jan-Egbert Sturm, Katsuyoshi Nakazawa, Keigo Kameda, Koichi Fukumura,
Takahiro Watanabe, and Yukihiro Nishimura for their valuable comments and suggestions. We also thank Takashi
Kuramoto and the participants of the Akai Seminar at Osaka University and Kansai public economics workshop for
their comments and the Cross Boundary Innovation Program of Osaka University, JSPS KAKENHI Grant Number
JP18J12301, and the DENTSU scholarship foundation for financial support. The authors are responsible for any
remaining errors.
† Graduate School of Economics, Osaka University. Research Fellow of the Japan Society for the Promotion of Science.
1-7 Machikaneyama, Toyonaka, Osaka 5600043, Japan. Tel.: +81-80-61222768 Email:sge010gt@student.econ.osakau.ac.jp‡ Graduate School of Economics, Osaka University. 1-7 Machikaneyama, Toyonaka, Osaka 5600043, Japan.

11 Introduction
Creative accounting*1 has begun to be recognized as an important topic when examining government
debt accumulation as well as political and economic crises. For example, the creative accounting employed by the Greek government was said to be one major reason behind the Greek debt crisis in theearly 2010s (Spiegel, 2010; Siskos & Marangos, 2017). In many developing countries such as Malaysia
and South Africa, scandals about the fiscal manipulation employed by politicians or governments cameto light; as a result, corruption has been regarded as a barrier to development. To address this situation,
the Fiscal Transparency Code proposed by the International Monetary Fund (IMF) prescribes a standard
for disclosing information on public finance (International Manetary Fund, 2014). The implementationof this code is expected to reduce fiscal manipulation such as creative accounting.
Moreover, to reduce fiscal manipulation further, we need to elucidate its mechanism. However, understanding what causes fiscal manipulation is diﬃcult for two main reasons. Firstly, the causality offiscal manipulation is usually challenging to ascertain. Although the existence of creative accounting isseemingly closely tied to increases in debt, whether attempts to use creative accounting raise debt or
attempts to raise debt lead to creative accounting is unknown*2 . Secondly, creative accounting is diﬃcult
to be observed and is only identified through detection. Thus, the available data may only pertain to
the number of detected incidents. These barriers prevent us from obtaining a comprehensive overview
of creative accounting.
Based on the foregoing, this study aims to overcome these diﬃculties by focusing on amalgamations oflocal governments, namely municipal mergers. As a result, we can use publicly disclosed data in Japan,
not detected data, to clarify that the incentive to increase debt causes the use of creative accounting
rather than attempts to use creative accounting causing debt issuance.
Municipal mergers amplify the incentive of municipalities to increase debt before the merger since theburden of the debt repayment is shared by the whole merged municipality; in other words, only part ofthe debt is owed by the municipality which issued the debt and the other part will be repayed by theother merger counterparts. This is called the “fiscal common pool problem”.
We observe creative accounting based on the fiscal common pool problem caused by municipal mergers.
Municipalities have an incentive to increase debt before the merger because of the fiscal common poolproblem, while financial restrictions and monitoring by others limit the room for debt issuance. However,such a limitation may be avoidable if municipalities can increase their debt in secret by using creative
accounting. Thus, municipalities employ creative accounting before the merger if possible. We construct
the proposed theoretical model based on this basic idea. Moreover, because Japanese municipalities,
most of which experienced municipal mergers in the 2000s, could have employed creative accounting to*1 We define creative accounting as an act of intentionally publishing the financial indexes which do not reflect the real

financial status. Whether it is legal or illegal, creative accounting under this definition will be deleterious to thesoundness of public finance.
*2 For example, Siskos & Marangos (2017) point out the possibility of both causalities by observing the Greek debt
crisis.

2

exploit their special accounts before FY2007, we employ this situation to investigate the existence of
creative accounting due to municipal mergers.
In the theoretical analysis, we construct a simple three-period model with two asymmetric municipalities (i.e., the population of each municipality is diﬀerent). With this model, we examine three cases:(1) the benchmark case in which the municipalities are independent, (2) the merger case in which themunicipalities merge in period 2, and (3) the restriction case in which the municipalities merge in period
2 and are restricted from increasing debt but can employ creative accounting. By using this setting, wetheoretically show several results and clarify the mechanism of creative accounting.
Firstly, we prove that a municipality participating in the merger rationally attempts to issue moredebt than usual without creative accounting because of the fiscal common pool problem in the merger
case. We also show that the incentive to increase debt is larger for a municipality with a small population(called a “village” in this paper) than a municipality with a large population (called a “city”) since alarger burden of the debt repayment will be owed by the city than the village.
Secondly, in the restriction case, we clarify that the incentive to increase debt causes the use of creative
accounting and that a municipality with a stronger incentive tends to employ creative accounting more
fiercely, by examining the behavior of the village, which has a stronger incentive to issue debt than thecity. The result of the restriction case indicates that the village increases debt and employs creative
accounting, while the city does not employ creative accounting and may even reduce debt issuance before the merger. This result suggests that any attempt to increase debt leads to the use of creative
accounting. Hence, we show the mechanism of creative accounting by focusing on municipal mergers.
Thirdly, we show that the transparency and expected punishment when the use of creative accounting
is exposed reduce the amount of excessive debt and lessen the severity of creative accounting. This finding suggests that measures to reduce the opacity in accounting such as the IMF’s Fiscal Transparency
Code work to prevent creative accounting and excessive debt accumulation.
These results suggest that creative accounting is caused by municipal mergers, although it is uncertain whether the results hold in reality. Therefore, we verify these theoretical results in an empiricalanalysis. In the empirical part, we employ data on the widespread Japanese municipal mergers in the
2000s because Japanese municipalities can have utilized creative accounting at that time. Indeed, they
were restricted from issuing debt if their financial index, called real balance ratio, was low. However,they could manipulate their real balance ratio by reducing the money transfer from the general accountto special accounts, because this ratio only captures the financial status of the general account. Because
data on debt issuance, the real balance ratio, and money transfers are publicly accessible—even though
there was a time lag from the occurrence of creative accounting to the data publication of at least one
year in the 2000s and creative accounting schemes were not as popular then—we can analyze the useof creative accounting by Japanese municipalities. Through a diﬀerence-in-diﬀerence (DID) analysis,
the empirical results show that small municipalities, which were expected to have a stronger incentive
to increase debt, utilized creative accounting, verifying the theoretical results. As a result, this study
theoretically and empirically shows the mechanism of creative accounting.
Although we focus on creative accounting by governments, this study is related to two strands of the3literature: creative accounting and the fiscal common pool problem*3 .
The first strand, creative accounting, is the main focus of this study. Although grasping the mechanism
and causality of creative accounting is usually diﬃcult as explained above, several empirical works haveattempted to investigate it, primarily focusing on the tendency of governments to use fiscal manipulation.
Koen & van den Noord (2005) research accounting gimmicks and their determinants in EU countries,
which were expected to follow the Maastricht Treaty. They point out that decentralized governments
and governments with deficits tend to use these gimmicks, although the mechanism is unknown and theresult is based only on the detected number of gimmicks. von Hagen & Wolﬀ (2006) show similar results
about creative accounting in EU countries; however, they focus on the stock flow adjustment as a tool ofcreative accounting rather than the number of fiscal gimmicks. While the causality is still unknown, theyshow that creative accounting by using this adjustment was employed at the time of the introduction of
the euro*4 . Clemenceau & Soguel (2017) identify the factors influencing the use of creative accounting
in the public sector, using 1980–2002 panel data on Swiss cantons, which are based on detected data.
They suggest that the background of mayors explains the occurrence of creative accounting well. In
Japan, Hirota & Yunoue (2017a) suggest that Japanese municipalities employ creative accounting toevade infringing on the new law for sound finances, although the mechanism and causality of creative
accounting are vague. While several empirical studies of creative accounting exist, theoretical researchis scarce. The exception is Milesi-Ferretti (2003), who shows that the introduction of severe fiscal rules
reduces the room for creative accounting, although myopic governments with deficits still employ budget
gimmickry to behave as if they adhere to the fiscal rules. The important result of Milesi-Ferretti (2003) isthat the larger penalty or expected loss from violating the fiscal rules reduces deficit amounts, although
the author assumes the existence of a myopic government and that irrationality explains the occurrenceof creative accounting. Our study fills the shortfalls of these works empirically and theoretically andhelps explain the mechanism of creative accounting.
In terms of the second strand, the basic mechanism of the fiscal common pool problem is that whenseveral groups utilize a common budget, they do not use their own budgets. This is similar to “thetragedy of the commons.” The fiscal common pool problem has long been theoretically analyzed (Weingast et al. , 1981; Persson & Tabellini, 1994; Velasco, 2000; Krogstrup & Wyplosz, 2010), althoughempirical studies have been limited since finding treatments and controls has been diﬃcult. However,by focusing on municipal mergers, empirical researchers have begun to observe the fiscal common poolproblem*5 . Before municipal mergers, municipalities can free-ride and issue considerable debt because of
the fiscal common pool problem. In many countries, empirical researchers have shown that municipalities*3 In addition, this study deals with the regulation of finance by subnational governments(e.g., Ter-Minassian, 1997;

Singh & Plekhanov, 2005; Foremny, 2014; Martinez-Vazquez & Vulovic, 2016; Heinemann et al. , 2016; Burret &Feld, 2018; Heinemann et al. , 2018).
*4 Maltritz & Wuste (2015) also investigate the relationship between creative accounting and the primary budget balancein EU countries as well as summarize empirical studies of the influence of fiscal rules on fiscal performance.
*5 Hinnerich (2009) and Jordahl & Liang (2010) investigate the fiscal common pool problem in the mergers of Swedishmunicipalities. Hansen (2014), Saarimaa & Tukiainen (2015), and Fritz & Feld (2015) show the common pool problem
in Denmark, Finland, and Germany, respectively. Japanese municipalities are investigated by Nakazawa (2016) and
Hirota & Yunoue (2017b).

4

issue excessive debt before their mergers happen, using the DID method as an identification strategy
in which the municipalities to be merged are treatments and the others are controls. Corresponding tothis, theoretical studies began to deal with the common pool problem caused by municipal mergers. For
example, Akai & Goto (2018) show that municipalities issue excessive debt before they merge by using
a simple two-period model*6 . Although many studies have pointed out that the fiscal common poolproblem causes the accumulation of considerable debt, whether the fiscal common pool problem leads tocreative accounting has been unclear until now. This is our contribution to this strand of the literature.
The remainder of the paper consists of five sections. The theoretical model and its implications arepresented in Section 2. Section 3 presents the empirical analysis, where the institutional background ofJapanese local governments, data, and methodology are explained as well as the results of the analysis. Section 4 discusses the results of the theoretical model and empirical analysis. Finally, Section 5
concludes.

2 Theoretical model and its implication
In this section, we deal with the three-period model with two asymmetric municipalities. The modelis based on Milesi-Ferretti (2003), who analyzes creative accounting, and Akai & Goto (2018), who show
the fiscal common pool problem in municipal mergers.

2.1 Model setting
Consider an economy with three periods (denoted as τ = 0, 1, 2) and two municipalities called a “city”
and a “village” (denoted as i = c, v). The city has n consumers, whereas the village has only one
consumer. A consumer in i enjoys a publicly supplied good xiτ in period τ and receives utility u(xiτ )(u′ > 0 and u′′ < 0 are assumed). Utility in period 2 is discounted by the discount factor δ ∈ (0, 1] whenevaluated in period 1. A benevolent government in each municipality i supplies a good xiτ individuallyin period τ , utilizing an endowment per person, ωτ . In addition, each municipality can issue debt,
denoted di *7 per person, in period 1 as a fund, which has to be repaid in period 2 with an interest rater. Since a small open economy is assumed, r is virtually exogenous. Therefore, the budget constraint ofmunicipality i is{
ψi ω1 + ψi di = ψi xi1
ψi ω2 − (1 + r)ψi di = ψi xi2 ..

(1)

ψi takes ψc = n and ψv = 1 for i = c, v.
In the theoretical part, we consider three cases: (1) the benchmark case in which the city and village
are independent throughout all periods, (2) the merger case in which the city and village are independent
in period 1 and merge in period 2 with no restriction on borrowing, and (3) the restriction case in which
the city and village have a restriction on debt issuance, are independent in period 1, and merge in period*6 Goto (2017) also theoretically deal with the fiscal common pool problem and municipal mergers.
*7 Although di is called debt here, it may be savings since we do not limit the range of di specifically. Therefore, it canbe interpreted as savings if di < 0 and as debt if di ≥ 0.

5

2. Municipalities tend to issue more debt than the ordinal level when they face municipal mergers.
This phenomenon, the fiscal common pool problem, is described in the merger case. The restriction
case corresponds to the model of Milesi-Ferretti (2003), who deals with creative accounting in public
sectors. In this case, a reference point is set to ensure that municipalities do not overissue debt, whilemunicipalities can issue more debt than the reference point by utilizing creative accounting and incur acost for that. Unlike Milesi-Ferretti (2003), the reference point can be endogenously determined in thismodel*8 . As a result of this restriction case, we find that only the village employs creative accounting,while the city reduces its debt when the reference point is set.
The implications explained above can be derived from the model. However, some may think thatthe city will not merge (i.e., it has an incentive to deviate from the merger) since it knows that it will
repay the cost of the merger later. To avoid such a deviation, we assume that when municipalities
merge, an incentive, Ic+v , is distributed to each consumer in the merged municipality from a higher
level of government such as the national government*9 . This assumption is natural, considering theactual situation of municipal mergers*10 . As a result, although these is a distortion about the good
allocation, the utility of a consumer in the merger case and restriction case may be higher than that in
the benchmark case, which has no distortion about a good allocation.
The timing of the game is as follows:
0 The reference point, d∗ , is exogenously determined by the national government (or endogenously
determined by a negotiation between the city and village*11 ). If a municipality prefers not toparticipate in the merger, it can quit here.
1 Each municipality decides xi1 and di .
2B Each municipality decides xi2 .
2M After the municipal merger, a united government of the merged areas decides xc2 and xv2 .
The setting of the reference point d∗ in period 0 is only applied for the restriction case since the othercases have no reference point d∗ . In the merger case and restriction case, municipalities choose whether
to join the merger by considering the incentive Ic+v in period 0*12 . If they decide to participate in themerger, a united government is formed and it decides xc2 and xv2 in period 2, after each of them decides
xi1 and di in period 1. Thus, period 2 in the merger case and restriction case corresponds to 2M above.
In the benchmark case, each municipality decides xi1 and di in period 1 and xi2 in period 2, as described*8 We examine this setting in Appendix A7.
*9 In this model, Ic+v aﬀects the utility of residents, which means that it can be not only a pecuniary incentive but alsoa psychological incentive. Although it may be an odd assumption, if you consider the utility function as quasi-linear
function and Ic+v works as a pecuniary numeraire there, Ic+v can be interpreted naturally. Moreover, though thesource of Ic+v is not described here, we can describe it by assuming that there are N pairs of city and village andthe upper government levies a lump-sum tax T on each resident of all municipalities to finance the incentives (Since
T is a lump-sum tax and does not cause any distortion, we can omit to describe the existence of it.).
*10 For example, the Japanese government provided incentives to accelerate municipal mergers in the 2000s (the socalled the great Heisei mergers). The concrete measures taken in Japan are explained in the institutional backgroundsection.
*11 In Appendix A7, we examine the endogenous setting of the reference point.
*12 The benchmark case does not have a period 0 since the municipalities decide whether to merge by referring to thebenchmark case in the other cases.

6

in 2B above. The game is solved by backward induction and the equilibrium concept in this model isthe subgame perfect Nash equilibrium.

2.2 Benchmark caseIn this case, municipalities are independent throughout all periods and there is no distortion for a good
allocation.
The utility maximization problem for municipality i in period 2 iss.t. ψi (ω2 − (1 + r)di ) = ψi xi2 .

max ψi u(xi2 )xi2

ψi takes ψc = n and ψv = 1 for i = c, v. The Lagrangian of this problem is
Vi ≡ ψi u(xi2 ) + λi ψi {ω2 − (1 + r)di − xi2 }.
The first-order condition shows∂Vi= ψi u′ (xi2 ) − λi ψi = 0∂xi2
and λi = u′ (xi2 ) is derived.
The utility maximization problem for municipality i in period 1 ismax ψi u(xi1 ) + δVi

xi1 ,dis.t. ψi (ω1 + di ) = ψi xi1 .

The Lagrangian here isWi ≡ ψi u(xi1 ) + δVi + µi ψi {ω1 + di − xi1 }.
From the first-order conditions, we can derive∂W= ψi u′ (xi1 ) − µi ψi = 0∂xi1∂W= −(1 + r)δλi ψi + µi ψi = 0∂diand, summarizing these conditions, we obtainu′ (xi1 ) = (1 + r)δu′ (xi2 ).

(2)The budget constraints per consumer areω1 + di = xi1
ω2 − (1 + r)di = xi2
in either municipality i and (2) is also obtained. Therefore, with the subscript B showing the benchmark
B
B
B
B
B
case, we can derive xB
1 ≡ xc1 = xv1 and x2 ≡ xc2 = xv2 here. In addition, satisfying (2), the benchmark
Bdebt level is determined as dB ≡ dB
c = dv .

7

2.3 Merger caseIn this case, the city and village are independent in period 1 and merge in period 2. Since thegovernments are benevolent, a united government provides goods to maximize the sum of the utility of
all consumers in c and v in period 2, while each government of municipality i supplies goods to maximize
the utility of the consumer(s) in i in period 1.
The utility maximization problem for the united government in period 2 ismax nu(xc2 ) + u(xv2 ) + (n + 1)Ic+v

xc2 ,xv2

s.t. ω2 (n + 1) − (1 + r)(ndc + dv ) = nxc2 + xv2 .
Ic+v is the per capita incentive for municipal mergers. The Lagrangian of this problem isV ≡nu(xc2 ) + u(xv2 ) + (n + 1)Ic+v+ λ{ω2 (n + 1) − (1 + r)(ndc + dv ) − nxc2 − xv2 }.

(3)

The first-order condition for i is∂V= ψi u′ (xi2 ) − λψi = 0∂xi2
MM
and λ = u′ (xc2 ) = u′ (xv2 ) is derived. Therefore, for xi2 satisfied here, xM
2 ≡ xc2 = xv2 can be definedwith the subscript M , which represents the merger case.
nof VConsidering the utility satisfied in each municipality, the utility for consumers in the city is n+1
1
and that for the consumer in the village is n+1
of V . Therefore, the objective function of the government

in i in period 1 ismax ψi u(xi1 ) + δ

xi1 ,diψiV
n+1

s.t. ψi ω1 + ψi di = ψi xi1 .

(4)

ψi takes ψc = n and ψv = 1 for i = c, v. The Lagrangian of this problem is
Wi ≡ ψi u(xi1 ) + δ

ψi
V + µi {ψi ω1 + ψi di − ψi xi1 }n+1

and the first-order conditions are∂Wi= ψi u′ (xc1 ) − µi ψi = 0
∂xi1
∂Wi
ψi
=−
(1 + r)δψi λ + ψi µi = 0.
∂din+1
By summarizing these conditions and denoting the subscript M as the optimized solution in this case,
we obtainu′ (xMi1 ) =

ψi(1 + r)δu′ (xM
2 ).
n+1

(5)

In period 0, each municipality chooses whether to join the merger. The condition for ensuring participation in the merger is WiM ≥ WiB . In the following part of this case, we only focus on the case where
8the incentive for the merger Ic+v is suﬃciently large to satisfy WiM ≥ WiB for both municipalities*13
and investigate what happens there compared with the benchmark case.
We first obtain the proposition indicating the fiscal common pool problem in municipal mergers.
Proposition 1 The total debt issued in the merger case is larger than that in the benchmark case, namely
MBndM
c + dv > (n + 1)d .

(Proof) See Appendix A1.
Many empirical studies such as Hinnerich (2009) empirically show that the debt issuance of mergedMmunicipalities is larger than that of non-merged municipalities on average. If we divide ndM
c + dv >(n + 1)dB by n + 1, this proposition explains the phenomenon shown in these empirical studies since
the municipality in the benchmark case of our model can be seen as a non-merged municipality. Thisphenomenon is the fiscal common pool problem.
Proposition 1 shows the total debt amount between the benchmark case and merger case. Additionally,
we can obtain some implications about the debt per capita and diﬀerence between the debt issuance ofthe city and village. From (5), the optimum condition for each municipality in the merger case isn(1 + r)δu′ (xM
2 )
n+1
1
(1 + r)δu′ (xMu′ (xM2 ).
v1 ) =
n+1
u′ (xMc1 ) =

(6)
(7)

M
′ M
M
M
′′
M
From (6) and (7), we can obtain u′ (xMc1 ) = nu (xv1 ), and xc1 < xv1 holds from u < 0. Thus, dc < dvMM
holds in this case because xM
2 = xc2 = xv2 holds and the endowment per capita is the same acrossmunicipalities. Moreover, we can show that the per capita debt of the village in the merger case isB *14
always larger than that in the benchmark case, namely dM. Therefore, the debt issuance by thev >dvillage is always excessive in the merger case.
On the contrary, we cannot show that the debt issuance by the city is always excessive in the merger
case. Although merged municipalities issue more debt than non-merged municipalities on average, mergedmunicipalities with a large population may issue less debt than non-merged municipalities. We summarize
this as the following proposition.
M
B
B
Proposition 2 Although dM
< dM
< dM
c < dv and dv always hold, dc is not always satisfied anddB ≥ dMc can be shown when the city’s population n is suﬃciently large.
(Proof) See Appendix A2.
Appendix A2 shows that dB ≥ dM
c is obtained if n ≥ 1 + δ (δ ∈ (0, 1]) holds in the case in which theutility function is a natural logarithm function such as u(x) = log(x). Indeed, this number is not solarge since, in reality, mergers between a small municipality and a large municipality whose size is more
*13 There are other equilibria where W M
i< WiB holds for either municipality and the results obtained there coincidewith the benchmark case.
*14 The proof of this condition is in Appendix A1.

9than twice that of the small one can be observed easily. Therefore, the situation of dB ≥ dM
c is likely tohappen.

2.4 Restriction case
2.4.1 Setting of the restriction caseIn the merger case, total issued debt is larger than that in the benchmark case. To reduce debt there,
consider the case in which a per capita debt ceiling, d∗ , is set (i.e., the reference point). Municipalities
are supposed not to issue more per capita debt than d∗ . If a municipality issues more per capita debt
than d∗ , it receives punishment K, which is subtracted from per capita utility*15 . The punishment inthis model aﬀects the utility of residents, which means that it can be not only a pecuniary punishment
but also a psychological impairment*16 .
Despite the existence of the punishment, municipalities can avoid such a penalty by employing creative
accounting, namely by declaring a false per capita debt amount ∆i as their issued debt amount insteadof the true amount di . With creative accounting, a municipality can issue more debt than d∗ , although
it has to bear the punishment K if creative accounting is detected. Creative accounting is detected withprobability p:γ
p = min{1, (di − ∆i )2 }.
2(8)

γ is an index showing the transparency of the municipality and p rises if γ increases.
If the true debt is di ≤ d∗ , municipality i has no incentive to declare a false debt amount and employ
creative accounting. Therefore, di = ∆i ≤ d∗ holds. On the contrary, municipality i whose debt is
di > d∗ has an incentive to use creative accounting and declare a false debt amount as ∆i satisfies
di > ∆i = d∗ . This is because the municipality has to bear the punishment if it declares ∆i > d∗ andthe probability p increases if it declares ∆i < d∗ . In addition, for simplicity and to ensure the inner
solution, we assume that γ2 (di − ∆i )2 < 1 is always satisfied following Milesi-Ferretti (2003)*17 .
In this game, d∗ can be determined endogenously by each municipality in period 0 before it decides xi1and di in period 1. Moreover, from both the endogenous and the exogenous setting of the reference point,
we can derive similar results. However, in the Japanese municipal mergers in the 2000s, the reference
point d∗ was determined exogenously. Therefore, we assume that d∗ is determined exogenously in themain part of this paper and deal with the endogenous setting of d∗ in Appendix A7.

*15

Although, a municipality that increased its debt before the merger may be penalized after the merger in reality, thepunishment K appears in period 1 in this model. This is because even if we introduce K in period 2, we have toevaluate the disutility of K in period 1 eventually because K should only be applied to the municipality that increased
its debt before the merger, not the other municipality. Thus, if you think the punishment should be realized in period
2, please consider K ′ ≡ K
as the punishment realized in period 2 and evaluate it in period 1 as K = δK ′ , which isδequivalent to the original model.
*16 This means that the bad reputation or disadvantage provoked by excessive debt issuance harms the utility of residents.
Moreover, this model allows that such a punishment is realized after the merger as footnote *15 explains.
*17 Actually, we do not have to assume γ (di − ∆i )2 < 1 since this condition always holds for the presence of large K.
2
Although we examine this in Appendix A3, we assume γ2 (di − ∆i )2 < 1 here for simplicity.

102.4.2 The solution of the restriction case
The objective function of the government in period 2 is the same as that in the merger case:max nu(xc2 ) + u(xv2 ) + (n + 1)Ic+v

xc2 ,xv2

s.t. ω2 (n + 1) − (1 + r)(ndc + dv ) = nxc2 + xv2 .
The Lagrangian of this problem is the same as (3) and is shown as V . By solving this, we obtainx2 ≡ xc2 = xv2 . The existence of the reference point does not aﬀect this result, which holds evenwhen one municipality issues more debt than the reference point and the other issues less debt than thenreference point. Moreover, the utilities for the consumers in c are n+1
of V and that for the consumer
1in v is n+1
of V .

In this case, the objective function of the government in i in period 1 is modified from that in themerger case. A term showing the punishment is added if di > d∗ holds since municipality i uses creative
accounting. However, because there is no need for a municipality to employ creative accounting if di ≤ d∗holds, the objective function in period 1 is the same as that in the merger case. Therefore, we only focus
on the case of di > d∗ in this section since the solutions in the case of di ≤ d∗ have already been derived
in the merger case.
When di > d∗ holds, municipality i sets its false debt amount as ∆i = d∗ and the objective functionin period 1 ismax ψi u(xi1 ) − ψi Kp + δ

xi1 ,diψiV
n+1

s.t. ψi ω1 + ψi di = ψi xi1 , p =γ(di − d∗ )2 .
2

ψi takes ψc = n and ψv = 1 for i = c, v. The Lagrangian of this problem isγψi
WiR = ψi u(xi1 ) − ψi K (di − d∗ )2 + δ
V + µi ψi (ω1 + di − xi1 ),2
n+1
where we use the subscript R to show the restriction case. The first-order conditions are∂WiR= ψi u′ (xi1 ) − ψi µi = 0
∂xi1
∂WiR
ψ2
= −ψi Kγ(di − d∗ ) − (1 + r)δ i λ + ψi µi = 0.
∂din+1
By summarizing these equations, we can deriveu′ (xRi1 ) = δψiR∗(1 + r)u′ (xR2 ) + Kγ(di − d ).
n+1

(9)

By using (5) and (9), we can see the eﬀect of the restriction, the introduction of which reduces debt
issuance. Summarizing this fact, we obtain the following proposition.
Proposition 3 When a municipality issues more debt than the reference point, the existence of therestriction reduces debt issuance.
(Proof) See Appendix A4.

11

This proposition indicates that debt issuance can be reduced by the existence of the restriction because
municipalities bear punishment for excessive debt issuance with a positive probability even if they use
creative accounting. This proposition thus implies that setting a restriction for borrowing is a good
policy for reducing excessive debt. In reality, Nakazawa (2016) shows that Japanese municipalities witha restriction on their debt issuance do not increase their debt compared with municipalities without arestriction before their mergers. Thus, this proposition explains that phenomenon.
Proposition 3 shows the eﬀect of the restriction itself. In addition, we can show the following proposition related to the eﬀect of high transparency and heavy punishment.
Proposition 4 Higher transparency and a heavier punishment reduce the debt amount and creative
accounting more.
(Proof) See Appendix A5.
This proposition suggests that measures to enhance transparency eliminate excessive debt and lessen
the use of creative accounting. This implication encourages policies such as the IMF’s Fiscal Transparency
Code that aim to prevent excessive debt issuance.
Moreover, we can show that dc ≤ dv holds regardless of the existence of the restriction. We havealready confirmed that dc ≤ dv holds in the solution of the merger case and we can apply this in the
restriction case if di = ∆i ≤ d∗ holds for both is. In addition, no equilibrium such as d∗i < dv < dc or
dv ≤ d∗ < dc is achieved*18 . Therefore, we obtain the following proposition.
Proposition 5 When the city and village merge, dc ≤ dv always holds regardless of the existence of therestriction.
This proposition indicates that the village’s incentive to issue debt is always stronger than the city’s.
Since the occurrence and extent of creative accounting increase when debt issuance is large in this model,
this result suggests that the village, which has a strong incentive to increase debt, tends to employ creative
accounting more fiercely than the city. Moreover, we can derive the following proposition*19 .
Proposition 6 Only the village increases debt dv and employs creative accounting, while the city reduces
debt dc and does not use creative accounting if the reference point is set as the same level as nonmerged municipalities’ debt issuance and the diﬀerence in the population between the city and village is
suﬃciently large.
This proposition refers to two conditions. The first concerns the reference point. If this is set as thesame level as non-merged municipalities’ debt issuance, d∗ = dB holds since non-merged municipalities
issue dB as their debt amount, as we show in the benchmark case. The second condition requires thatthe diﬀerence in the population between the city and village, which is equal to n, is suﬃciently large.
Proposition 2 shows that the village always increases debt, while the city reduces debt if n is suﬃciently*18 See Appendix A6 for these proofs.
*19 We can derive a similar proposition even if we assume that the reference point d∗ is endogenously determined.

Appendix A7 on this.

12

See

large. Hence, we can derive this proposition because debt issuance above d∗ (= dB ) entails creative
accounting and only the village’s debt issuance is applied to this.
In this model, debt issuance beyond dB is excessive because dB is the debt issuance level at whichmunicipalities decide optimally with no distortion. Therefore, it is natural to set the reference point as
dB to eliminate excessive debt. Thus, the result of Proposition 6 is likely to happen in the real world.
As explained in the next section, the reference point for Japanese municipalities was indeed considered
to satisfy the two conditions of Proposition 6. This means that the results of Proposition 6 can beverifiable by using data on Japanese municipalities. The next subsection discusses the possibility for theverification of this result.

2.5 Applications for the empirical analysis
From the theoretical model, we find that a municipality with a smaller population always employs
creative accounting, while the other municipality with a larger population does not when the debt
reference point is set. However, there is a problem when we apply this model to the empirical analysis.
Is the reference point set before the municipal merger in reality? This is important, since without thereference point, creative accounting does not occur in the model. The existence of the reference point
can be observed in reality, although the real framework is not the same as the model assumes.
Japan*20 , for example, has financial indexes called the real balance ratio and the debt expenditure ratio.
When a municipality has excessive debt, capturing the financial conditions, these indexes worsen. If amunicipality has suﬃciently large debt to lower its index below the reference point of the real balance ratio
or debt expenditure ratio, the national government keeps the municipality from issuing new debt*21 . In
addition, Japanese municipalities in 2000s used these financial indexes to judge whether the counterpart
in the merger negotiation had sound finances. “The guideline for operating the amalgamation committee”(Ministry of Internal aﬀairs and Communications, 2006) published by the national government provided
that “municipalities are expected to disclose their fiscal conditions completely as early as possible andto discuss mergers based on this information” (Ministry of Internal aﬀairs and Communications, 2006,p.57). The fiscal conditions disclosed in the earlier negotiation stage reflect each municipality’s fiscal
conditions in the previous period. Since many municipalities in Japan followed this guideline during
merger negotiations, we can assume that they used the disclosed fiscal information on the previous period
as a reference point of the financial conditions. In addition, if the financial conditions of municipalities
worsened and this was exposed to their merger counterparts, they might be punished in the merger
negotiation*22 . Thus, it is also reasonable to assume the existence of the punishment K as well as the*20 We deal with the Japanese case here since we use Japanese data in the empirical analysis. However, regulations forborrowing and setting reference points for financial conditions are common globally. For example, such a restriction
for subnational governments is set by the national or state governments in Australia, Belgium, Brazil, Germany,
Hungary, Korea, Norway, Spain, and the United States.
*21 Nakazawa (2016) shows that municipalities with a high debt expenditure ratio refrain from issuing new debt before
their mergers, verifying the result of Proposition 3. We utilize the real balance ratio in the regression instead of thedebt expenditure ratio. Both these ratios can be manipulated if the scheme we explain later is utilized.
*22 For example, the reduction in public services has been one controversial problem in merger negotiations in Japan,
as such services were expected to be integrated. Hence, if considerable debt issuance by a municipality was exposed

13existence of the reference point d∗ in the model.
Considering these factors, we can assume that Japanese merged municipalities set their reference
point for the fiscal deficit as their previous fiscal conditions*23 . Therefore, throughout the empiricalanalysis, we assume that Japanese municipalities followed the guideline (Ministry of Internal aﬀairs andCommunications, 2006) and referred to their previous fiscal conditions (i.e., they set their reference point
exogenously)*24 .

3 Empirical analysis
In this section, the institutional background of Japanese municipal mergers, data, methodology, andresults of the analysis are explained. We focus on the massive Japanese municipal mergers in the
2000s since Japanese municipalities may have employed creative accounting at that time. By using DID
analysis, we verify the result of Proposition 6, which shows that only small municipalities employ creative
accounting, while large municipalities reduce their debt.

3.1 Institutional background3.1.1 Local public finance in JapanThe Japanese government system consists of three tiers: the national government, prefectural governments, and municipal governments. As Figure 1 shows, there were 47 prefectures in Japan and 1727
municipalities at the end of FY2010.
Figure 1 is here.
Municipalities provide most local public services. However, since the scale of municipalities varies fromvillages with under 200 people to cities with millions of people, the work of municipalities are diﬀerent by
their types. There are two main categories of municipalities and three subcategories of cities as Figure
1 shows. Although the names (i.e., “town” and “village”) are diﬀerent, the role of towns and villages is
the same and they are usually small and in rural locations. A “city” is a large municipality that provides
wider local public services than a town or village does. Cities are subcategorized into “designated cities,”“core cities,” and “special cities.” All three categorizes have larger populations and wider works thanordinal cities. The criteria to become a city or a categorized city are diﬀerent and becoming a designatedcity is the most diﬃcult.
during a negotiation, that municipality would lose its bargaining power and public service provision would reduce in
its area. As this decreases the benefit for residents, we can consider that the municipality receives a punishment asa result.
*23 Even if municipalities endogenously set the reference point as they like, the result obtained from period 0 of themodel is realized as shown in Appendix A7, although this is not considered to happen in reality.
*24 Here, the previous period is equivalent to the pre-treatment period and the previous financial conditions are thefinancial conditions during the pre-treatment period in Figure 8 of Appendix B1. In this period, municipalities did
not know whether they would merge. By contrast, during the treatment period, they joined the merger negotiationand thus could have expected a merger to occur. Therefore, small municipalities should increase their debt issuanceand employ creative accounting in the treatment period, while large municipalities should decrease their debt if their
population is suﬃciently large.

14

The revenue of municipalities’ general account mainly comprises three parts. First, Local Tax (LT)accounts for about 30% of the revenue of municipalities. While municipalities levy several types ofLT, most tax revenue comes from resident tax and property tax. Another main revenue source formunicipalities is grants from the national government (approximately 30% of revenue). There are twonational grants: Local Allocation Tax (LAT) and national Treasury disbursements. LAT is allocated tomunicipalities considered to have a money shortage, and can be utilized for general purposes. The amountof LAT is based on the estimated money shortage, which is calculated by the national government*25 .
National Treasury disbursements are an earmarked subsidy that municipalities can only use for specificpurposes. The other source is Local Bonds (LB), accounting for 10% of municipal revenue. LB is mainly
issued for construction purposes. Usually, although municipalities have to ask whether they might issue
LB to the upper government such as the prefecture government or national government, they could issue
LB virtually freely if they had sound finances. However, if the debt expenditure ratio or real balance
ratio of a municipality is evaluated as bad, the issuance of LB is regulated. Therefore, municipalities
have an incentive to employ creative accounting to improve their financial index and thus evade thisregulation.
3.1.2 The great Heisei mergers and merger negotiations
Japan experienced large-scale municipal mergers called “the great Heisei mergers” in the 2000s. Before
this series of mergers, the Municipal Amalgamation Law (the old law) was enacted in 1965. Although
the old law tried to promote mergers, only 147 mergers were implemented from 1965 to 1999.
However, in 1999, the old law was radically amended and many incentives for mergers were oﬀered.
For example, merged municipalities were guaranteed to receive the same amount of LAT for 15 years,
even though this is usually reduced since they are expected to become more eﬃcient. Moreover, otherincentives were oﬀered that aﬀected the merger decision, just as the incentive Ic+v aﬀects the merger
decision in the theoretical model. In Japan, the amount of these incentives, equivalent to Ic+v , diﬀered
among municipalities based on the particular conditions of each*26 . This means that the merger decision
can be interpreted as determined exogenously since the incentive amount strongly induced municipalities
to merge, as the theoretical model showed, even though the merger decision was nominally determinedby each municipality. Therefore, we assume that the merger treatment was assigned exogenously*27 .
To accelerate municipal mergers, the national government oﬀered plans and guidelines for use during*25 This estimated money shortage is calculated based on the expected revenue and expenditure, which are also calculatedby the national government depending on various conditions such as population and land area, which are diﬃcult to
be manipulated by municipalities.
*26 For example, as noted above, the amount of LAT is calculated by the national government depending on the estimatedmoney shortage, which cannot be manipulated by municipalities. Since merged municipalities were guaranteed toreceive the same amount of LAT for 15 years, the exogenous determination of LAT can be interpreted as equivalent
to the exogenous determination of Ic+v in the theoretical model.
*27 Most previous studies of municipal mergers assume that the merger decision is exogenously assigned even if they deal
with voluntary mergers (Hinnerich, 2009; Jordahl & Liang, 2010; Hansen, 2014; Saarimaa & Tukiainen, 2015; Fritz& Feld, 2015; Nakazawa, 2016). By using the theoretical model, we can justify this view when the incentive amountfor merger Ic+v is diﬀerent among municipalities, as in the Japanese case. Thus, we adopt this view in the empiricalanalysis.

15

negotiations. These guidelines obligated municipalities to take 20 to 22 months for negotiations; indeed,
the actual negotiation time was 20.2 months on average (Ministry of Internal aﬀairs and Communications,
2006; Nakazawa & Miyashita, 2016). Moreover, it was announced that the incentives to promote mergers
would stop at the beginning of FY2006, when the amended old law would be replaced by the new law. As
a result, most series of mergers were conducted until FY2006 (see Figure 2.). These promotions strongly
induced municipal mergers and led to many municipalities initiating merger negotiations. Eventually,
the number of municipalities reduced from 3229 (at the end of FY1999) to 1727 (at the end of FY2010).
Figure 2 is here.
As Figure 2 shows, mergers in FY2004 and FY2005 were particularly common because negotiations
were expected to take about two years and most municipalities could not take actions quickly after theamended old law was published. The typical process of these mergers started from the formation of anamalgamation committee among the municipalities. If municipalities wanted to merge and receive the
incentives from the national government, they had to create a statutory amalgamation committee. On
these committees, municipalities discussed how and when they would merge in detail. Committees wereusually dissolved when they failed to negotiate a merger*28 .
3.1.3 Municipal fiscal rules and creative accounting
In Japan, “the law for local public financial reconstruction” (the previous reconstruction law) enacted
in 1955 obliged all local governments to publish a real balance ratio every year. This index is calculated
based on the general account, with most special accounts not considered*29 . Under the previous reconstruction law, municipalities were supposed to keep their real balance ratio above -20% every year. If theyfailed to do so, they would be designated financial reconstruction bodies and put under the control of thenational government*30 . Although the new law for sound finances*31 enacted in 2008 added indexes tocapture the financial status from several dimensions including all special accounts, the financial status of
special accounts was not grasped precisely under the previous reconstruction law. Thus, municipalities
were assumed to employ creative accounting more easily before 2008 than after.
Figure 3 is here.

*28 See Nakazawa & Miyashita (2016), Nakazawa (2016), and Hirota & Yunoue (2017b) for more details.
*29 According to the White Paper on Local Public Finance (e.g., Ministry of Internal aﬀairs and Communications, 2010),

the composition of this index is below:
Real balance ratio =Real budget balance of the general account and etc.
.
Standard financial scale

The real budget balance is found by subtracting carry-over expenditure in the next year from the budget balanceof the current year, which reduces as LB issuance increases. Although the number of special accounts diﬀers bymunicipality, only a few special accounts are usually considered in the real balance ratio among about 20 special
accounts. The share of these special accounts was only 3.4% of all the special accounts of all municipalities in 1997.
See Akai & Ishikawa (forthcoming) in detail.
*30 While many municipalities were designated financial reconstruction bodies before the 1970s, only 17 were designatedthus from 1975 to 2007. These 17 municipalities failed to transform industrial structures and made huge deficits(Doi, 2007).
*31 This is the same law as Hirota & Yunoue (2017a) investigate.

16

All municipalities divide their accounts into two broad categories, as Figure 3 indicates: the generalaccount and special accounts. Special accounts consist of three accounts for public health and several
accounts for public enterprises. The number of special accounts varies by municipality since each has
diﬀerent public enterprises. There are approximately 20 types of special accounts and most are excluded
when calculating the real balance ratio. Municipalities freely decide the money transfer between thegeneral account and special accounts. Large transfers from the general budget to special budgets areusually used to compensate for deficits in special accounts. In particular, special accounts related to
public health are negatively aﬀected by the aging population*32 .
The typical method of creative accounting was to reduce the money transfers from the general budget
to special budgets*33 . According to anecdotal evidence, a mayor of a municipality in Osaka prefecture
confessed that his municipality had employed such a creative accounting scheme and struggled with therepayment of accumulated debt in special accounts as a result*34 . This implies that some municipalities
may have employed it before their mergers.

3.2 Hypotheses
R
∗
M
B
R
From the theoretical analysis, we derive dM
c < d < dv and ∆v = d , where dc and dv represent the

debt issuance per person of a large and a small merged municipality, respectively, dB is the debt issuance
per person of the non-merged municipality, and ∆v is the observable false debt issuance of the small
municipality. In addition, since municipalities set the reference point as high as their previous deficit∗Rlevels before their mergers, dM
c < d < dv is assumed. As a result, the theoretical result suggests that

only small municipalities employ creative accounting and increase their debt, while large municipalities
do not employ creative accounting and reduce their debt before the merger.
Considering this, we can make the following hypotheses.
Hypothesis 1 Small municipalities to be merged increase debt issuance before their mergers and large
municipalities to be merged reduce it compared with non-merged municipalities.
This hypothesis concerns real debt issuance (i.e., the amount of LB issuance). We use this variable,
called “LB issuance per capita,” to capture the movement of debt issuance by each municipality.
While LB issuance indicates real debt issuance, the financial conditions and punishment such as regulation for borrowing were judged by the real balance ratio in Japan, although this ratio could bemanipulated by reducing money transfers. Therefore, we investigate money transfers and the real balance ratio to check whether creative accounting existed. If the theoretical model is right, the following
hypotheses will hold.

*32 Special accounts are expected to be managed by the benefit principle and earn their revenue by collecting a service

fee, although their revenue tends to be lower than their expenditure. Nishizawa (2015) points out that most moneytransfers in local governments are chronic since special accounts usually run deficits.
*33 Akai & Ishikawa (forthcoming) explain the scheme in detail and point out municipalities can use this scheme easily.
Yano (2008) finds that municipalities could utilize this scheme easily in Japan. Iwamoto (1996) also points out thata similar creative accounting scheme was adopted by the national government of Japan.
*34 Refer to his speech on February 11, 2017 at the Kansai public economics workshop.

17

Hypothesis 2 Small municipalities to be merged reduce their money transfers from the general accountto special accounts before their mergers.
Hypothesis 3 The real balance ratio of small municipalities to be merged is almost the same as that ofnon-merged municipalities.
Hypothesis 2 focuses on the extent to which municipalities employed creative accounting. If municipalities
manipulated their fiscal indexes by reducing money transfers to special accounts, the reduced amountwould correspond to dRv − ∆v , which is the gap between the real debt amount and false debt amount,
and only small merged municipalities would reduce money transfers. Hypothesis 3 captures the outcomeof creative accounting. If small merged municipalities manipulate their real balance ratio, the trend of
the real balance ratio should be similar to that of the others. This corresponds to the results of thetheoretical model, which showed that villages manipulate their own financial conditions.
In addition, how we determine small and large is important. In the baseline analysis, we use therelative size of the population in the merged municipality to assess whether a merged municipality islarge or small. The relative size of the population is calculated as
populationi
The relative size of the populationi ≡ ∑j populationj(10), where i, j shows the index of the merged municipality. By using this, we define a large merged municipality as a municipality whose relative population is larger than 0.5 because the verification of thetheoretical model requires that the relative population of a large merged municipality exceeds 0.5*35 .
Such a criterion is set in previous research (For example Hirota & Yunoue, 2017b) and is natural to verify the result of the theoretical model. For the robustness check, we implement regressions with changing
the definition by determining cities as large municipalities and villages and towns as small municipalities.
However, these changes in definition do not aﬀect the main results of the empirical analysis*36 .

3.3 Data and method
To verify the three hypotheses, we employ linear regressions with three variables as the dependent
variables: LB issuance per capita, money transfer per capita, and the real balance ratio. Thus, we set
the DID linear regression model as follows:
Yi,t,j =αj + β1j P ostt × T reatmenti,t + β2j P ostt × T reatmenti,t × Largei+ β3j T reatmenti + β4j Largei + β5j P ostt′
+ β6j
Citysizei,t + β7j P opi,t + β8j Areai,t+ β9j LATi,t−1 + β10j LTi,t−1 + εi,t,j .
*35

(11)

To verify the result of Proposition 6, the population of large municipality n must be suﬃciently large. Moreover, from
Appendix A2, we can find that n such as n > 1 + δ is suﬃciently large if the utility function is the natural logarithm
function. Since δ ∈ (0, 1], n should be in (1, 2] at least. In this situation, the relative population of a suﬃciently
large municipality should be more than (0.5, 32 ] because the population of a small municipality is normalized to 1.
Therefore, we adopt 0.5 as the criterion. In addition, even if we use 2/3 as the criterion, the result does not change
a lot.
*36 The results of this analysis are available upon request.

18

In this model, i and t show each municipality and year, respectively since the data are balanced panel
data. In addition, because three regressions are investigated in this study, Yi,t,j represents LB issuanceper capita, money transfer per capita, and the real balance ratio, and j corresponds to each dependent
variable in this equation*37 . Since the data on these three dependent variables are publicly disclosed,
we can obtain a comprehensive overview of creative accounting that utilizes special accounts without
depending on detected data, which may fail to capture some creative accounting. Moreover, these data
are published annually and usually released at the end of the next financial year. In other words, thetime lag to identify creative accounting is at least one year. Therefore, each municipality could hidecreative accounting for at least one year.
The treatment eﬀects are captured by the terms P ostt ×T reatmenti and P ostt ×T reatmenti ×Largei .
T reatmenti is a dummy variable coded one if municipality i merges. Largei is a dummy taking one if
the relative size of the municipality exceeds 0.5*38 . P ostt takes one if that year is one or two year(s)before the merger because the negotiation period was assumed to range from 20 to 22 months*39 . Figure
8 in Appendix B1 summarizes the timings and stages of the municipal mergers in the 2000s in Japan. In
addition to the cross-terms, we add T reatmenti , Largei , and P ostt to the model, which are necessary
for the DID analysis.
Hypothesis 1 is verified if the signs of the regression for LB issuance per capita correspond to β1bond > 0
and β2bond < −(β1bond ) < 0. This is because small merged municipalities are expected to increase theirdebt, whereas large merged municipalities are presumed to reduce their debt. In the regression formoney transfer per capita, the signs should be β1transf er < 0 and β2transf er = −(β1transf er ) > 0 to
verify Hypothesis 2 because small merged municipalities reduce money transfers to special accounts toimprove the real balance ratio, while the money transfers of large merged municipalities remain the same
as before. To verify Hypothesis 3, the sign should be β1real = 0 in the regression on the real balance
ratio because the real balance ratio of small merged municipalities should remain the same if creative
accounting is successful. On the contrary, the coeﬃcient for β2real should be positive or zero because
the real balance ratio of large merged municipalities improves since they reduce their LB issuance (theirreal balance ratio will not move if the reduction in LB issuance is insuﬃcient). Table 1 summarizes the
expected results.
Table 1 is here.
The control variables in this model are P opi,t , Areai,t , LATi,t−1 , LTi,t−1 , and Citysizei,t . P opi,tand Areai,t show the population and area of each municipality, respectively. LATi,t−1 and LTi,t−1 are
the previous year’s LAT and LT, respectively. These variables capture the fiscal conditions of each municipality. Citysizei,t consists of four dummy variables: the designated city dummy, core city dummy,
special city dummy, and city dummy. The designated city (core city/special city/city) dummy takes one*37 Hence, j takes j = bond in the regression on LB issuance per capita, j = transf er in the regression on money transfer

per capita, and j = real in the regression on the real balance ratio.
*35 for the determination of this criterion.
*39 See p.16 for more details. In addition, since Hirota & Yunoue (2017b), who investigate the same Japanese municipal
mergers as this study and the fiscal common pool problem, set the treatment period as two years for their DID
analysis, this treatment period should be reasonable.
*38 See footnote

19

if a municipality is a designated city (core city/special city/city) and zero otherwise. These dummies
capture the specific role of each municipality. αj and εi,t,j represent the constant term and error term,
respectively.
In this study, panel data are employed to investigate the regressions of the LB issuance per capita,
money transfer per capita, and real balance ratio. Since we examine the behaviors of municipalities
before their mergers, the utilized data should be pre-mergers’ data*40 . For the analysis, we use twodatasets: one contains data on 3068 municipalities for FY1997–2003 and the other contains data on
2249 municipalities for FY1997–2004. For each dataset, the treatment group consists of municipalities
that merged just after the end of the data period. For example, the treatment group for FY1997–2003
consists of the municipalities that merged in FY2004. Each dataset starts from FY1997, since the major
LT reform was implemented in FY1997, implying that the structural change may aﬀect the result if data
before FY1997 are utilized.
Table 2 and Table 3 show the summary statistics by treatment group and control group*41 . Table 4summarizes the data sources.
For the parallel trend assumption for the DID method, the employed data seem to satisfy the assumption according to Figure 4 and Figure 5. The left, center, and right graphs show the trend of LB
issuance per capita, money transfer per capita, and the real balance ratio, respectively. These figures
show that the parallel trend started to be broken two years before the mergers, which correspond to
the treatment period. Only small merged municipalities increase their debt and radically decrease theirmoney transfers compared with non-merged municipalities, while their financial indexes retain the same
trend. By contrast, large merged municipalities seem to decrease their debt compared with non-mergedmunicipalities; however, they keep their money transfer level and the financial index the same.
The parallel trend can also be ensured by using a placebo test. Appendix B3 presents the results ofthe placebo test of each regression, which satisfy the parallel trend assumption.
Table 2, Table 3, and Table 4 are here.
Figure 4 and Figure 5 are here.

3.4 Empirical results
Table 5 and Table 6 show the empirical results. In general, these results verify the expected signs andcoeﬃcient values for each regression.
Firstly, for the regression on LB issuance, β1bond > 0 and β2bond < −(β1bond ) < 0 are expected from thetheoretical model. Although there is an exception in the result for the FY1997–2004 data, the expected
results are obtained in the FY1997–2003 data. Therefore, Hypothesis 1 is verified: small municipalities
increased debt issuance before their mergers.
Secondly, β1transf er < 0 and β2transf er = −(β1transf er ) > 0 are expected for the regression on money*40 Appendix B1 explains the data construction.
*41 Appendix B2 presents the summary statistics by small and large municipalities within the treatment group.

20

transfers. Since these results can also be observed from Table 5 and Table 6, we can verify Hypothesis
2. Thus, only small municipalities employed creative accounting, while large municipalities did not.
Finally, β1real = 0 is expected for the regression on the real balance ratio. This result supports
Hypothesis 3: the financial indexes of small municipalities did not worsen because they employed creative
accounting. In addition, corresponding to the expectation of β2real = 0, the coeﬃcients of β2real are notsignificant in Table 5 and Table 6. These results correspond to the expected results.
These results generally show that only small merged municipalities employed creative accounting
and issued excessive debt, while large merged municipalities did not. In particular, the result fromthe FY1997–2003 data shows that large merged municipalities reduced their debt before their mergers,which corresponds to the results of the theoretical model. This finding is a novel contribution to previous
research. To summarize, we generally show results that concur with the theoretical model.
Table 5 and Table 6 are here.

3.5 Robustness check
As a robustness check, we analyze the model without control variables and the fixed eﬀect model.
The results obtained from the former show similar results to the baseline model. In the latter, variables
with collinearity with the fixed eﬀects are omitted; however, the results are similar. Therefore, we canconclude that the results obtained are robust.
Table 7, Table 8, Table 9, and Table 10 are here.

3.6 Possibility of alternative mechanisms
The empirical results obtained here verify the results of the theoretical model. However, there may bealternative explanations for the empirical results. In this part, we consider these alternatives and showthat they cannot explain the empirical results obtained here.
Firstly, Milesi-Ferretti (2003) suggests that myopia causes the use of creative accounting. However, wecannot justify that only the governments of small merged municipalities suddenly became myopic before
their mergers. Thus, this explanation is unlikely to hold.
The second possibility is the background of mayors, as Clemenceau & Soguel (2017) show. However,this cannot explain the fact that small merged municipalities did not employ creative accounting in the
pretreatment period because many mayors were the same in the both pretreatment period and treatment
period.
The third explanation is the introduction of new financial rules (Koen & van den Noord, 2005; vonHagen & Wolﬀ, 2006). In Japan, new financial rules for municipalities were gradually introduced from
FY2007. However, because these rules started to be discussed from FY2006 (Akai & Ishikawa, forthcoming), the municipalities in our dataset (FY1997–2003/2004) must not have been aﬀected by theirintroduction.

21

To summarize, other explanations cannot be provided for our empirical results. Therefore, we conclude
that the incentive to increase debt issuance causes the use of creative accounting before mergers, as thetheoretical model shows.

4 Discussion
The theoretical model and empirical analysis allow us to clarify that small municipalities utilize creative
accounting before their mergers. However, some points remain to be considered.
For example, the theoretical model has two asymmetric municipalities (large and small). However,mergers with more than three municipalities occur in reality. That said, a similar result can be obtainedeven if the number of municipalities in the model rises because a merger with even more municipalities
disperses the burden of issued debt and causes a more serious fiscal common pool problem. In otherwords, when the number of merged municipalities is high, each municipality can free-ride more easily*42 .
Therefore, the incentive to increase and hide debt will be strengthened. This fact might explain why
our results from the empirical analysis concur with those of the theoretical model even though theused dataset contains mergers with more than two municipalities. Another possible point is about theappropriateness of assuming a symmetric endowment per person. In reality, municipalities in Japanutilize revenue such as LT and LAT, but not endowments, to provide public services. Since Japanesemunicipalities can receive LAT to bridge their estimated money shortage, revenue per capita cannot varya lot. Therefore, the assumption of a symmetric per capita endowment used in the theoretical model isconsidered to be appropriate.
For the empirical analysis, we use two datasets to examine how small and large municipalities issued
LB and transferred money to special accounts as well as to check how the fiscal index moved. The
obtained result generally shows that only small merged municipalities increase LB issuance and reduce
money transfers before their mergers, while their real balance ratio remains the same; large mergedmunicipalities reduce LB issuance. However, in the FY1997–2004 data, although β1bond > 0 is realized,
not β2bond < −(β1bond ) < 0 but 0 > β2bond > −(β1bond ) is observed, which is diﬀerent from the expected
result. This means that large merged municipalities increased their debt in the treatment period, while
the increase was not as large as that of small merged municipalities. This is perhaps because thediﬀerence in the size of the population between large and small merged municipalities was insuﬃcient for
the former to reduce their bond issuance. Table 11 and Table 12 show that the diﬀerence in population
between them is larger in the FY1997–2003 data than in the FY1997–2004 data. In addition, althoughβ2bond < −(β1bond ) < 0 is not obtained from the FY1997–2004 data, we can confirm that LB issuanceis larger in small merged municipalities than in large merged municipalities. Thus, this finding largely
verifies the results of the theoretical model.

*42 See Akai & Goto (2018) for more details.

22

5 Conclusion
This study investigates whether creative accounting tends to be employed before municipal mergers.
We build a theoretical model and verify its results by using balanced panel data on Japanese municipalities. The theoretical model shows that only a small municipality employs creative accounting since it has
a strong incentive to increase debt because of the fiscal common pool problem. The empirical analyses
show that small merged municipalities issue more debt and reduce money transfers to special accounts
to hide debt, while their fiscal indexes remain the same thanks to creative accounting.
Although this study thus sheds light on the mechanism of creative accounting caused by municipal
mergers, research on creative accounting is scant and several points still need to be solved. Hence, moresophisticated future research is needed.

Appendix A
Appendix A1
M
BM
B
The proof of ndM
c + dv > (n + 1)d and dv > d .

(Proof)B
M
Assume ndM
c + dv ≤ (n + 1)d . Under this assumption, we can deriveMndM
c + dv =n+1
n+1
B(ω2 − xM
(ω2 − xB
2 )≤2 ) = (n + 1)d .
1+r
1+rThis holds if and only if
BxM
2 ≥ x2 .

(A1)Since the utility function is concave, this can be transformed to′ B(1 + r)δu′ (xM2 ) ≤ (1 + r)δu (x2 ).
′ M
′ B
′ M
′ B
Thus, by using (2) and (5), we can obtain u′ (xMc1 ) + u (xv1 ) ≤ u (x1 ). This means that u (xc1 ) < u (x1 )′ B
and u′ (xMv1 ) < u (x1 ) hold here (See (5).). Therefore, this leads to
BMB
xM
c1 > x1 , xv1 > x1 .

(A2)

Considering the resource constraint of this economy, from (A1) and (A2), we can derive that
1
n+1 M
M
ω2 ) = nxMxc1 + xv1 +
1+r
1+r 2
1
1
> (n + 1)(xB
xB ) = (n + 1)(ω1 +
ω2 ).
1 +
1+r 2
1+r

(n + 1)(ω1 +This inequality is obviously wrong since the left- and right-hand sides have to be equal. This is aM
BM
contradiction. Therefore, ndM
holds here. In addition, since dM
c + dv > (n + 1)d
c < dv is alreadyshown, we can derive thatM
M
B
(n + 1)dM
v > ndc + dv > (n + 1)dB
and dMv > d can be shown. (Q.E.D.)

23

Appendix A2
BM
In this section, we show that dB < dM
c is not always satisfied and that d > dc can be obtained when

the city’s population n is suﬃciently large.
M
B
M
B
Since ndM
c + dv > (n + 1)d is satisfied, x2 < x2 can be derived (see (A1)). By using this fact, we
B
MB
firstly show that dM
c > d does not always hold. Assuming dc > d holds, we can derive thatM
BB
ω1 + dMc = xc1 > x1 = ω1 + d

and, since the utility function is concave, this is′ B
u′ (xMc1 ) < u (x1 ).

By substituting (2) and (5), we can obtainn′ Bu′ (xM2 ) < u (x2 ).
n+1

(A3)

B
′ M
′ B
However, since xM
2 < x2 always holds and u (x2 ) > u (x2 ) can be drawn here, the inequality (A3) willB
not always be satisfied (e.g., consider n → ∞). Therefore, dMc ≤ d can occur.
B
Next, we show that dM
holds if the city’s population n is suﬃciently large. When the utilityc ≤ dBfunction is a natural logarithm function, u(xiτ ) = log(xiτ ), dMc ≤ d is satisfied when n ≥ 1 + δ. Thiscan be shown as follows:B
If u(xiτ ) = log(xiτ ) holds, u′ (xiτ ) = x1iτ can be obtained. When dMc ≤ d is satisfied, we can derive

that
M
B
B
ω1 + dMc = xc1 ≤ x1 = ω1 + d

and the concavity of the utility function leads this to′ B
u′ (xMc1 ) ≥ u (x1 ).

By substituting (2) and (6) into this, we deriven′ Bu′ (xM2 ) ≤ u (x2 )
n+1
m
nxB
2 ≤ (n + 1)x2 .

(A4)

From the budget constraint, (2), and (5),1n+1 M
(n + 1)(2 + δ) M
Mω2 ) = nxMx =x2
c1 + xv1 +
1+r
1+r 2
(1 + r)δ
(n + 1)(1 + δ) B
1
1=x2 = (n + 1)(xB
xB ) = (n + 1)(ω1 +
ω2 ).
1 +
(1 + r)δ
1+r 2
1+r(n + 1)(ω1 +

B
M δ+2
M δ+2
Therefore, we obtain xB
2 = x2 δ+1 . By substituting x2 = x2 δ+1 into (A4) and summarizing, we obtainn ≥ 1 + δ.

24

Appendix A3This section shows that in the restriction case γ2 (di − ∆i )2 < 1 is ensured for the presence of large K.
Total utility in the restriction case is
WiR = ψi u(xi1 ) − ψi Kp + δ

ψi
V + µi ψi (ω1 + di − xi1 ).
n+1

(A5)

p follows (8) and V is defined as (3) here.
If γ2 (di − ∆i )2 < 1 holds in the restriction case, from (A5), the total utility of area i is
R
R
WiR∗ ≡ WiR (xR
i1 , xi2 , di ),R
R
where (xR
i1 , xi2 , di ) follows (1) and (9).

On the contrary, if γ2 (di − ∆i )2 ≥ 1 holds in the restriction case, the total utility of area i is
M
M
M
M
M
M
WiR∗∗ ≡ WiR (xM
i1 , xi2 , di ) = Wi (xi1 , xi2 , di ) − K,M
M
where (xM
i1 , xi2 , di ) follows (1) and (5). This is because Kp = K holds in (A5) and the first-orderconditions of this case give us the same result as in (5).
In the restriction case, municipality i decides (xi1 , xi2 , di ) and maximizes WiR . In such a situation, if
M
M
R
R
R
K is larger than K ≡ WiM − W R∗ , municipality i will choose not (xM
i1 , xi2 , di ) but (xi1 , xi2 , di ) since
R
R
WiR∗ > WiR∗∗ holds here. Moreover, municipality i does not deviate from choosing (xR
i1 , xi2 , di ) since

WiR∗ and WiR∗∗ provide the maximum utility when γ2 (di − ∆i )2 < 1 and γ2 (di − ∆i )2 ≥ 1, respectively.
R
R
Therefore, a suﬃciently large K ensures that a municipality chooses (xR
i1 , xi2 , di ).

To summarize, in the restriction case, γ2 (di − ∆i )2 < 1 is ensured for the presence of a large K *43 .

Appendix A4
In this section, we show that when a municipality issues more debt than the reference point, theexistence of the restriction reduces debt issuance.
(Proof)
M
With the restriction, the debt level is dR
i , while the debt level is di without the restriction. From now,MRM
we show dR
i < di . Assume di ≥ di . Under this condition, we derive thatRMM
ω1 + dRi = xi1 ≥ xi1 = ω1 + di .
′ M
Therefore, marginal utility is u′ (xRi1 ) ≤ u (xi1 ) since the utility function is concave. By utilizing (5) and(9), this equation can be transformed into
δ

ψi
ψi
∗
(1 + r)u′ (xR(1 + r)δu′ (xM2 ) + Kγ(di − d ) ≤
2 ).
n+1
n+1

*43 Actually, assuming that K is suﬃciently large to satisfy K > K is natural. This is because a small K(≤ K) leads toexcessive debt issuance as well as in the merger case and it is thus meaningless to be set to prevent excessive debt
issuance even though the purpose of K is its prevention.

25

Since Kγ(di − d∗ ) > 0, this can be reduced toδψiψi(1 + r)u′ (xR(1 + r)δu′ (xM
2)<
2 ).
n+1
n+1

M
Therefore, the scale of x2 in each case is xR
2 > x2 . This means
RMM
ω2 − (1 + r)dRi = x2 > x2 = ω2 − (1 + r)di
M
R
M
R
M
and we can obtain dR
is shown.
i < di . However, this contradicts di ≥ di . Therefore, di < di

(Q.E.D.)

Appendix A5
In this section, we prove that higher transparency and a heavier punishment reduce the debt amountand creative accounting more.
(Proof)
1+r
From the budget constraint, we obtain xi1 = ω1 + di and x2 = ω2 − n+1(ndc + dv ). By substituting theminto (9), we can deriveu′ (ω1 + di ) = δ

ψi1+r(1 + r)u′ (ω2 −(ndc + dv )) + Γ(di − d∗ ).
n+1
n+1Γ ≡ Kγ(> 0) here. The diﬀerentiation of dc and Γ is1+rn
(1 + r))2 u′′ (ω2 −(ndc + dv )) + Γ}ddc + dc dΓ
n+1
n+1
dc
ddc
= ′′
⇔
< 0.
n
1+r
dΓ
u (ω1 + dc ) + δ( n+1 (1 + r))2 u′′ (ω2 − n+1(ndc + dv )) − Γu′′ (ω1 + dc )ddc = {−δ(v
We can also show dddΓ < 0. Since Γ shows the degree of transparency and punishment such as Γ = Kγ,

higher transparency and a heavier punishment reduce the debt amount more. In addition, since theextent of creative accounting is measured as di − d∗ in this model, less di means that the amount ofcreative accounting is lower. (Q.E.D.)

Appendix A6
In this section, we show that d∗i < dv < dc and dv ≤ d∗ < dc cannot hold.
(Proof to show that d∗i < dv < dc cannot hold.)
Assume dc > dv in the restriction case. Under this condition, we obtainω1 + dc = xc1 ≥ xv1 = ω1 + dv
and the concavity of the utility function leads this tou′ (xc1 ) ≤ u′ (xv1 ).
By substituting (9), we obtainδn1(1 + r)u′ (x2 ) + Kγ(dc − d∗ ) ≤ δ(1 + r)u′ (x2 ) + Kγ(dv − d∗ ).
n+1
n+1
26

(A6)

n
1
From n+1> n+1
and dc > dv , (A6) isδn1(1 + r)u′ (x2 ) + Kγ(dc − d∗ ) ≤ δ(1 + r)u′ (x2 ) + Kγ(dv − d∗ ).
n+1
n+1

Since dc > dv is assumed here, we obtainδ

1
1(1 + r)u′ (x2 ) + Kγ(dv − d∗ ) < δ(1 + r)u′ (x2 ) + Kγ(dv − d∗ ).
n+1
n+1

(A7)

However, the left- and right-hand sides of (A7) have to be equal. Thus, (A7) is a contradiction. Therefore,dc ≤ dv holds in the restriction case. (Q.E.D.)(Proof to show that dv ≤ d∗ < dc cannot hold.)
Assume dc > d∗ ≥ dv . Under this condition, we obtainω1 + dc = xc1 > xv1 = ω1 + dv .
Since the utility function is concave, we findu′ (xc1 ) > u′ (xv1 )and, using (9),δn1
(1 + r)u′ (x2 ) + Kγ(dc − d∗ ) ≤ δ(1 + r)u′ (x2 )
n+1
n+1

(A8)

1
n
> n+1
and Kγ(dc − d∗ ) > 0, (A8) is a contradiction. Therefore, dc > d∗ ≥ dv
should hold. From n+1

does not hold. (Q.E.D.)

Appendix A7
In this section, we extend the model and examine what happens when the reference point d∗ is endogenously determined by municipalities in period 0.
We consider that municipalities decide d∗ by a negotiation between them in period 0 assuming theirutility is higher if they merge. The realized reference point d∗ is determined as d∗ = βd∗c + (1 − β)d∗v ,where d∗i is i’s desired reference point and β ∈ (0, 1) is an exogenous weight that represents bargaining
power. The higher β, the higher is the city’s bargaining power. Each municipality simultaneously setsd∗i to maximize i’s utility before the negotiation. We assume that the incentive Ic+v is suﬃciently largethat both municipalities decide to participate in the merger. Under these settings, the objective functionof municipality i in period 0 is
max
WiR
∗
di

s.t. WiR ≥ WiB , d∗ = βd∗c + (1 − β)d∗v ,

(A9)

R R
R ∗
R ∗
R ∗
where the optimal xR
i1 , x2 , di s are determined by (9) and can be denoted as xi1 (d ), x2 (d ), di (d ). The

Lagrangian about (A9) is
ŴiR ≡ WiR + νi (WiR − WiB ).

27

Before solving, we have to obtain the conditions about the diﬀerentiations. The total diﬀerentiation of(9) isu′′ (xRi1 )dxi1 = δ
and we can obtain

ψiR∗(1 + r)u′′ (xR2 )dx2 + Kγddi − Kγdd
n+1

 R
∂xi1

= − u′′Kγ


(xR
i1 )
 ∂dR∗∂x2Kγ∂d∗ = γ ψi (1+r)u′′ (xR )

2
n+1


 ∂dR
i
=
1
∗
∂d

.

Furthermore, we can obtain the following diﬀerentiation about d∗i :
{ ∗
∂d
=β
∂d∗
c
.
∂d∗
∂d∗ = 1 − βv

Denote β̄i as the variable that shows β̄c = β and β̄v = 1 − β. By using the diﬀerentiations and thisnotation, the first-order condition is∂ ŴiR
∂dR
∂d∗
∂xR
i
∗
− Kγ(dR− ∗ }+=(1 − νi )ψi β̄i [u′ (xi1 ) i1
i − d ){
∗
∗
∗
∂di
∂d
∂d
∂d
∂V ∂xR∂V ∂dR
∂dR
∂xR
δ
i
i1
i
{ R i2+}+µ(−)] = 0.
iRn + 1 ∂x2 ∂d∗∂d∗∂d∗∂di ∂d∗You can substitute Kγ = 0 if di (d∗ ) < d∗ is expected here, although this does not aﬀect the result. Since
R

∂di
∂V
∂V
′
′
= 0, ∂d
R = −(1 + r)ψi λ, u (xi1 ) = µi , u (x2 ) = λ, and ∂d∗
∂xR
i
i2
i

= 1 can be used here, we obtain∂ ŴiRδ(1 + r)ψi λ] = 0= (1 − νi )ψi β̄i [u′ (xi1 ) −
∗
∂di
n+1
ψi
⇒ u′ (xR(1 + r)δu′ (xRi1 ) =
2 ).
n+1This condition corresponds to (5). Therefore, each municipality sets its desired reference point as d∗i =*44 . This may be a surprising result because the village can set a higher d∗ to escape from thedMvireference point and, although the city can choose a lower d∗c to reduce its debt, they do not do so. As
a result, this condition shows that each municipality has an incentive to set d∗i as dM
i . One possible
explanation is that if the city sets a lower d∗c , the realized d∗ may become lower than dM
c , where the city
may receive a punishment.
The realized reference point isMMMd∗ = βd∗c + (1 − β)d∗v = βdM
c + (1 − β)dv ∈ (dc , dv ).
∗M
R
From this, firstly, we can obtain dM
c < d < dv . However, the realized debt amount of dv is dv here,*45 . As a result, dM < d∗ < dR holds in thesince the village’s debt issuance above d∗ should be dR
cvv

equilibrium. Summarizing this, we get the following proposition.
*44 For the second-order condition, we can check*45 Firstly, since d∗∂ 2 ŴiR∂xR< 0 using ∂di1
∗
∂d∗2
i

∂xR

and ∂d2∗ .

< dM
v always holds and the village has an incentive to adopt creative accounting, the objective∗Rfunction will not be (4) and dM
v is not obtained in the equilibrium. Secondly, assume d ≥ dv . Under this assumption,

28

Proposition 7 In the restriction case in which the reference point is endogenously set, the village, amunicipality with a smaller population, always uses creative accounting, whereas the city, a municipality
with a larger population, does not.
The village has a stronger incentive to issue debt than does the city. However, the more debt is above
the reference point, which is determined in the negotiation, the higher is the penalty. This leads thevillage to employ creative accounting to hide its debt and not be punished.

Appendix B
Appendix B1This appendix explains how we create the dataset. In this study, we focus on the municipalities thatare not merged yet since we investigate the strategic behaviors of pre-merged municipalities and theconditions of municipalities change dramatically. In addition, retaining data on municipalities to bemerged in the latest year of the dataset creates an unbalanced panel and may lead to poor estimators.
Therefore, we omit data on merged municipalities.
Figure 6, Figure 7, and Figure 8 are here.

Appendix B2Table 11 and Table 12 show the summary statistics for the merged cities and merged villages andtowns.
Table 11 and Table 12 are here.

Appendix B3
Table 13 and Table 14 show the results of the placebo test. In this test, we utilize the data fromFY1997 to FY2001 for the FY1997–2003 data and from FY1997 to FY2002 for the FY1997–2004 data.
As a pseudo-post-treatment period, we use FY2000 and FY2001 for the FY1997–2003 data and use
FY2001 and FY2002 for the FY1997–2004 data. The results confirm the parallel trend assumption.

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However,
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as
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v
v
v
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29

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31

Figures and tables
Figure1 Three-tier government system

Figure2 Transition in the number of municipalities

Data from Ministry of Internal aﬀairs and Communications (2016)

Figure3 Money transfer between the general account and special accounts

Data from Ministry of Internal aﬀairs and Communications (2010)32

Figure4 Trend of the 1997–2003 data

Figure5 Trend of the 1997–2004 data

Figure6 Composition of the municipalities data of 1997–2003

Figure7 Composition of the municipalities data of 1997–2004

33

Figure8 The timings and stages of Japanese municipal mergers in the 2000s

34

Table1 Expected results of the empirical hypotheses
Dependent variables
Expected trends
Expected coeﬃcients

LB issuance per capita
Decrease(for large)/Increase(for small)β2bond < −(β1bond ) < 0

Money transfer per capita
0 / Decrease
β2transf er = −(β1transf er ) > 0

Real balance ratio
Increase or 0 / 0
β2real ≥ β1real = 0

Table2 Summary statistics by group (3067 municipalities data of 1997–2003)

Control
Variable

Treatment

N

SD

mean

N

SD

mean

LB issuance per capita

15,771

89.58

76.59

5,705

93.80

95.89

Money transfer per capita

15,771

48.34

18.80

5,705

68.03

15.44

Real balance ratio

15,771

3.269

4.538

5,705

3.801

5.388

LT

15,7712.514e+07

6.082e+06

5,705

9.084e+06

2.757e+06

LAT

15,771

5.697e+06

2.925e+06

5,705

2.902e+06

2.442e+06

Area

15,771

15,131

12,489

5,705

7,666

9,127

Pop

15,771

121,781

40,621

5,705

60,35922,135

Designated city

15,771

0.06970.00488

5,705

0

0

Core city

15,7710.06000.00361

5,705

0.06860.00473

Special city

15,7710.07150.005145,705

0.05910.00351

City

15,771

0.428

0.241

5,705

0.335

0.129

Large

15,771

0

0

5,705

0.390

0.187

Table3 Summary statistics by group (2249 municipalities data of 1997–2004)

Control
Variable

Treatment

N

SD

mean

N

SD

mean

LB issuance per capita

9,984

89.92

73.60

8,008

83.76

78.26

Money transfer per capita

9,984

51.40

19.18

8,008

47.31

16.43

Real balance ratio

9,984

3.406

4.423

8,008

3.636

4.801

LT

9,984

3.105e+07

7.962e+06

8,008

1.357e+07

3.658e+06

LAT

9,984

6.614e+06

3.085e+06

8,008

4.109e+06

2.602e+06

Area

9,984

17,502

13,782

8,008

11,341

10,880Pop

9,984

147,821

51,293

8,008

77,07927,487

Designated city

9,984

0.08460.007218,008

0.04470.00200

Core city

9,984

0.06470.004218,008

0.06870.00475

Special city

9,984

0.08800.007818,008

0.06600.00437

City

9,984

0.458

0.299

8,008

0.376

0.170

Large

9,984

0

0

8,008

0.435

0.253

35

Table4 The source and scale of the data

Variables

SourceScale

LB issuance per capita

The Survey of Local Public FinanceThousand Yen

Money transfer per capita

The Survey of Local Public FinanceThousand Yen

Real balance ratio

The Survey of Local Public Finance

Population

System of Social and Demographic Statistics

Area

System of Social and Demographic Statistics

HectareLAT (lag)

The Survey of Local Public FinanceThousand Yen

LT (lag)

The Survey of Local Public FinanceThousand Yen

Designated city

System of Social and Demographic Statistics

Core city

System of Social and Demographic Statistics

Special city

System of Social and Demographic Statistics

City

System of Social and Demographic Statistics

36

Table5 The empirical results for the FY1997–2003 data

(1)OLS(2)OLS(3)OLS

LB issuance per capita

Money transfer per capita

Real balance ratio

13.63***-16.39***0.101(3.538)(3.044)(0.152)-19.22***16.43***-0.318(4.270)(3.239)(0.248)18.88***

2.430**

0.659***(1.918)(1.228)(0.0701)-19.74***-1.286-0.549***(2.401)(1.354)(0.120)6.485***

2.954***

0.360***(1.403)(0.860)(0.0577)

123.9***-28.12***

3.628***(13.29)(5.770)(0.823)33.89***-3.884**

1.239***(6.310)(1.652)(0.294)25.03***

6.681***-0.664**(3.274)(1.093)(0.296)-35.62***

7.786***-1.135***(1.011)(0.513)(0.0640)0.00150***0.000263***-3.65e-05***(5.47e-05)(3.59e-05)(1.45e-06)-0.000431***-6.44e-05***

7.68e-07(2.73e-05)(8.92e-06)(1.10e-06)

1.51e-06***

2.88e-07***-7.61e-09(1.33e-07)(4.22e-08)(4.64e-09)

1.32e-07

7.06e-07***-7.32e-08***(1.42e-07)(9.49e-08)(1.04e-08)

71.65***

11.71***

5.375***(1.144)(0.628)(0.0411)

Observations

21,476

21,476

21,476R-squared

0.122

0.017

0.089

Variable
Post×Treatment
Post×Treatment×Large
Treatment
Large
Post
Designated city
Core city
Special city
City
Area
Pop
LT
LAT
Constant

Robust standard errors in parentheses*** p<0.01, ** p<0.05, * p<0.1

37

Table6 The empirical results for the FY1997–2004 data

(1)OLS(2)OLS(3)OLS

LB issuance per capita

Money transfer per capita

Real balance ratio

12.94***-16.73***-0.0389(2.979)(2.051)(0.164)-9.318***16.11***-0.0393(2.979)(1.978)(0.218)2.979

2.638**

0.0612(1.859)(1.032)(0.0626)-15.68***-0.5670.104(1.841)(1.014)(0.0869)-2.5974.893***

0.621***(1.746)(1.275)(0.0817)128.7***-24.22***2.960***(12.00)(4.488)(0.784)29.99***-5.157***1.454***(5.825)(1.769)(0.326)28.76***

6.453***-0.600**(3.060)(1.036)(0.298)-31.56***

8.291***-1.224***(1.067)(0.593)(0.0713)0.00137***0.000329***-3.97e-05***(5.11e-05)(2.84e-05)(1.42e-06)-0.000413***-4.16e-05***

8.38e-07(2.39e-05)(7.72e-06)(1.09e-06)

1.41e-06***

2.15e-07***-7.16e-09*(1.10e-07)(3.36e-08)(4.29e-09)

2.72e-07**

4.51e-07***-6.49e-08***(1.28e-07)(6.93e-08)(9.84e-09)

72.67***

10.12***

5.373***(1.408)(0.754)(0.0500)

Observations

17,992

17,992

17,992R-squared

0.125

0.027

0.085

Variable
Post×Treatment
Post×Treatment×Large
Treatment
Large
Post
Designated city
Core city
Special city
City
Area
Pop
LT
LAT
Constant

Robust standard errors in parentheses*** p<0.01, ** p<0.05, * p<0.1

38

Table7 The empirical results for the FY1997–2003 data without the control variables(1)OLS(2)OLS(3)OLS

LB issuance per capita

Money transfer per capita

Real balance ratio

13.74***-16.29***0.0936(3.656)(3.042)(0.154)-17.62***16.38***-0.286(4.318)(3.246)(0.255)24.72***-0.724

1.169***(1.898)(1.170)(0.0686)-45.08***6.141***-1.773***(2.269)(1.286)(0.117)6.359***

2.692***

0.385***(1.495)(0.861)(0.0602)74.77***

18.03***

4.428***(0.872)(0.452)(0.0298)

Observations

21,476

21,476

21,476R-squared

0.024

0.006

0.026

Variable
Post×Treatment
Post×Treatment×Large
Treatment
Large
Post
Constant

Robust standard errors in parentheses*** p<0.01, ** p<0.05, * p<0.1
Table8 The empirical results for the FY1997–2004 data without the control variables(1)OLS(2)OLS(3)OLS

LB issuance per capita

Money transfer per capita

Real balance ratio

13.32***-16.59***-0.0534(3.145)(2.065)(0.167)-8.826***15.86***

0.00905(3.072)(1.994)(0.224)10.60***-1.3880.656***(1.802)(0.963)(0.0607)-34.46***7.070***-1.047***(1.744)(0.931)(0.0813)-3.078*4.600***

0.658***(1.856)(1.282)(0.0858)

74.37***

18.03***

4.259***(1.091)(0.568)(0.0373)

Observations

17,992

17,992

17,992R-squared

0.017

0.010

0.016

Variable
Post×Treatment
Post×Treatment×Large
Treatment
Large
Post
Constant

Robust standard errors in parentheses*** p<0.01, ** p<0.05, * p<0.1

39

Table9 The empirical results for the FY1997–2003 data with the fixed eﬀects

(1)FE

(2)FE

(3)FE

LB issuance per capita

Money transfer per capita

Real balance ratio

12.63***-15.05***0.0654(2.336)(2.538)(0.113)-18.39***15.04***-0.284(2.876)(2.748)(0.213)5.580***

3.032***

0.411***(1.024)(0.780)(0.0403)-0.8063.012***-0.0223(1.650)(1.004)(0.172)-1.6853.551***-0.0991(1.862)(0.881)(0.181)-0.00472***

0.00574***

1.43e-05(0.00119)(0.00163)(4.87e-05)-0.000459***-7.34e-05

1.36e-05(0.000139)(8.65e-05)(9.47e-06)-7.28e-07***3.22e-07***3.50e-08***(2.64e-07)(1.24e-07)(9.28e-09)-2.42e-06***

1.06e-06***

5.51e-08***(4.80e-07)(3.11e-07)(1.39e-08)

161.0***-50.62***3.658***(14.78)(19.25)(0.649)Observations

21,476

21,476

21,476R-squared

0.010

0.006

0.011

Number of Code

3,068

3,068

3,068

Variable
Post×Treatment
Post×Treatment×Large
PostCore city
Special city
Area
Pop
LT
LAT
Constant

Robust standard errors in parentheses*** p<0.01, ** p<0.05, * p<0.1

40

Table10 The empirical results for the FY1997–2004 data with the fixed eﬀects

(1)FE

(2)FE

(3)FE

LB issuance per capita

Money transfer per capita

Real balance ratio

12.96***-15.22***-0.0780(2.145)(1.801)(0.129)-10.12***14.98***

0.118(2.362)(1.841)(0.187)-3.966***4.955***

0.718***(1.259)(1.267)(0.0629)2.101

2.510***

0.0156(1.854)(0.902)(0.233)2.716

3.985***

0.0233(1.911)(0.939)(0.183)-0.00581***0.00646***

5.06e-05(0.00208)(0.00224)(7.24e-05)-0.000199-9.83e-06

3.07e-05***(0.000132)(6.54e-05)(1.09e-05)-3.76e-07**

2.06e-07**

5.69e-08***(1.85e-07)(1.00e-07)(1.49e-08)-1.62e-06***

7.27e-07***

9.47e-08***(3.44e-07)(2.41e-07)(2.70e-08)

163.0***-65.56**1.920*(26.49)(28.21)(1.026)

Observations

17,992

17,992

17,992R-squared

0.004

0.008

0.021

Number of Code

2,249

2,249

2,249

Variable
Post×Treatment
Post×Treatment×Large
PostCore city
Special city
Area
Pop
LT
LAT
Constant

Robust standard errors in parentheses*** p<0.01, ** p<0.05, * p<0.1

41

Table11 Summary statistics by large and small merged municipalities (FY1997–2003 data)

Small
Variable

Large

N

SD

mean

N

SD

mean

LB issuance per capita

4,641

99.78

105.2

1,064

41.29

55.12

Money transfer per capita

4,641

74.67

13.42

1,064

20.04

24.24

Real balance ratio

4,641

3.897

5.734

1,064

2.902

3.880

LT

4,641

902,496790,005

1,064

1.867e+07

1.134e+07

LAT

4,641

654,2431.772e+06

1,064

5.728e+06

5.365e+06

Area

4,641

6,380

7,777

1,064

9,746

15,015

Pop

4,641

7,221

8,288

1,064

121,791

82,533

Designated city

4,641

0

0

1,064

0

0

Core city

4,641

0

0

1,064

0.157

0.0254

Special city

4,641

0

0

1,064

0.136

0.0188

City

4,641

0.128

0.0166

1,064

0.486

0.618

Large

4,641

0

0

1,064

0

1

Table12 Summary statistics by large and small merged municipalities (FY1997–2004 data)

Small
Variable

Large

N

SD

mean

N

SD

mean

Money transfer per capita

5,984

53.07

13.64

2,024

20.95

24.68

LB issuance per capita

5,984

92.65

87.52

2,024

37.06

50.86

Real balance ratio

5,984

3.826

5.066

2,024

2.863

4.020

LT

5,984

1.145e+06

1.027e+06

2,024

2.539e+07

1.143e+07

LAT

5,984

777,239

1.857e+06

2,024

7.651e+06

4.806e+06

Area

5,984

9,819

9,119

2,024

13,69816,087

Pop

5,984

9,089

10,4572,024

140,985

77,836

Designated city

5,984

0

0

2,024

0.08860.00791

Core city

5,984

0

0

2,024

0.136

0.0188Special city

5,984

0

0

2,024

0.130

0.0173

City

5,984

0.161

0.0267

2,024

0.491

0.593

Large

5,984

0

0

2,024

0

1

42

Table13 Results of the placebo test for the FY1997–2003 data
(1) OLS(2)OLS
Variable
Bond per capita Money transfer per capita
Pseudo-Post×Treatment-0.0788
1.208(3.634)(2.004)
Pseudo-Post×Treatment×Large
4.586-5.351(4.561)(4.093)Treatment
19.33***
1.605(2.599)(1.295)Large-23.05***
1.829(3.156)(2.667)
Pseudo-Post-13.60***14.50***(1.616)(0.957)
Designated city
103.5***-25.71*(14.57)(13.66)
Core city
33.03***-9.264(10.77)(10.37)
Special city
27.74***-0.296(5.843)(9.563)City-34.50***7.092***(1.183)(1.272)Area0.00151***0.000241***(6.52e-05)(3.20e-05)
Pop-0.000425***-6.45e-05***(2.87e-05)(2.21e-05)
LT
1.47e-06***
2.98e-07***(1.38e-07)(9.50e-08)
LAT
3.03e-07*
5.99e-07***(1.62e-07)(1.66e-07)
Constant
76.24***
6.622***(1.491)(0.759)Observations
15,34015,340R-squared
0.114
0.031
Robust standard errors in parentheses*** p<0.01, ** p<0.05, * p<0.1(3)OLSReal balance ratio-0.0567(0.142)0.123(0.235)0.718***(0.0855)-0.691***(0.145)0.506***(0.0596)3.287***(0.897)0.940*(0.495)-1.003*(0.516)-1.030***(0.0713)-3.53e-05***(1.65e-06)
1.00e-06(1.18e-06)-8.46e-09*(4.90e-09)-6.79e-08***(1.13e-08)
5.114***(0.0477)
15,340
0.092

Pseudo-Post takes one if FY2000 and FY2001 and zero otherwise. The data are from FY1997 to FY2001.

43

Table14 Results of the placebo test for FY1997–2004 data
(1) OLS(2)OLS
Variable
Bond per capita Money transfer per capita
Pseudo-Post×Treatment
0.0172
1.134(3.439)(1.901)
Pseudo-Post×Treatment×Large-3.060-0.458(3.348)(3.008)Treatment
3.155
1.906*(2.361)(1.141)Large-14.88***0.254(2.376)(1.835)
Pseudo-Post-1.7195.623***(2.132)(1.168)Designated city
115.8***-25.27**(13.54)(12.65)
Core city
22.92***-7.898(8.715)(8.605)Special city
26.48***
2.952(4.557)(6.981)
City-31.68***7.644***(1.267)(1.266)Area0.00147***0.000300***(6.17e-05)(2.92e-05)
Pop-0.000424***-4.42e-05**(2.65e-05)(2.04e-05)
LT
1.44e-06***
2.26e-07***(1.20e-07)(8.54e-08)
LAT
3.27e-07**
4.62e-07***(1.47e-07)(1.48e-07)
Constant
72.15***
8.874***(1.697)(0.846)
Observations
13,494
13,494R-squared
0.120
0.022
Robust standard errors in parentheses*** p<0.01, ** p<0.05, * p<0.1(3)OLSReal balance ratio
0.0968(0.126)-0.151(0.167)0.0675(0.0755)
0.0763(0.104)0.138*(0.0772)2.758***(0.824)1.354***(0.434)-0.799*(0.439)-1.148***(0.0766)-3.75e-05***(1.52e-06)
1.20e-06(1.14e-06)-8.91e-09**(4.43e-09)-5.87e-08***(1.01e-08)
5.252***(0.0566)
13,494
0.088

Pseudo-Post takes one if FY2001 and FY2002 and zero otherwise. The data are from FY1997 to FY2002.

44