© 2018 Public Financial Publications, Inc.

Does Financial Slack Reduce Municipal

Short-Term Borrowing?
MIN SU AND W. BARTLEY HILDRETH

Many municipal governments face the challenge of temporary cash deficits due to
the mismatched schedules of cash flow-ins and flow-outs. To smooth the
temporary deficits, they can use either internal financial resources such as financial
slack or external financial resources such as short-term borrowing. This paper
applies the pecking order theory to examine municipal governments’ financial
preference when they experience cash flow problems. Results show that municipal
governments prefer accumulated financial slack to short-term borrowing when
both options are available. This finding demonstrates financial slack’s role as a
convenient cash management tool in municipal financial management. It also
suggests the applicability of the pecking order theory in future public financial
management research.

INTRODUCTION

Cash flow mismatch is a common issue in many municipal governments. During the normal
course of a fiscal year, the day-to-day revenue and expenditure flows of a governmental unit
are rarely equal. Many governments receive lump sum, scheduled payments of major revenue
sources once or twice a year, or at quarterly intervals. On the other hand, operating
expenditures, especially recurring expenses such as personnel costs are roughly constant
throughout the fiscal year. Figure 1 presents City of San Diego’s general fund cash flows to
illustrate this problem. The city receives property taxes from the County of San Diego twice
every fiscal year, creating two bulges in its cash flow-in trend: one in December and January,

Min Su is an Assistant Professor in the Public Administration Institute, E. J. Ourso College of Business, Louisiana
State University, 3045 Business Education Complex East, 501 South Quad Drive, Baton Rouge, LA 70808. She
can be reached at minsu@[Link].
W. Bartley Hildreth is a Professor of Public Management and Policy in the Andrew Young School of Policy
Studies, Georgia State University, P.O. Box 3992, Atlanta, Georgia, 30302-3992. He can be reached at
barthildreth@[Link].

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and the other in May and June.1 On the
expenditure side, except May and July, its APPLICATIONS FOR PRACTICE
monthly cash disbursements are fairly con- Financial slack (i.e., unreserved general fund
stant over the course of the year. The balances) reduces both the probability and the
amount of municipal short-term borrowing.
consequence of the mismatch between cash
flow-ins and flow-outs is temporary cash
The evidence that municipal governments
shortfalls during a fiscal year. As shown in prefer accumulated financial slack to short-
Figure 2, in absence of any cash management term borrowing supports pecking order theo-
ry’s claim that organizations prefer internal
strategy, the City would have a negative financing to external financing.
end-of-month cash balance seven out of
This study demonstrates the efficacy of
12 months. financial slack in subnational governments.
Besides serving as a cushion that protects
Managing government cash flows is not governments from risks, financial slack re-
simply a technical problem, but a critical duces municipal governments’ dependence on
issue in government financial management. short-term borrowing when liquidity is low,
For a municipal government, failure in suggesting it is a convenient cash manage-
ment tool in municipal financial management.
meeting its obligations of matured bond
Results from this study to some extent provide
principal and interest payments or in funding justification of government slack accumula-
expenditures in a timely manner could result tion as a precautionary management strategy.
in damaging consequences. To manage cash
flows, municipal governments can use either
internal financial resources such as accumulated financial slack or external financing tools such
as short-term borrowing if permitted by the state government. If both options are available, how
do municipal governments choose between internal financing and external financing? Do they
prefer one financing instrument to another? In this paper, we apply the pecking order theory
commonly used in corporate financial management studies that explains firms’ preference
ranking over various financial resources in the context of municipal governments. Using
financial data of California cities, we examine the following research questions:

Do municipal governments follow a pecking order of preference over internal and external
financial resources?

If so, does financial slack reduce municipal short-term borrowing?

1. In California, county governments collect property taxes through two equal installments. The first half taxes are
due November 1, four months after the start of a new fiscal year (i.e., July 1); if unpaid, the taxes are delinquent on
December 10. The Second half taxes are due the following February 1; if unpaid, they are delinquent on April 10.
Cities receive their shared property taxes after counties finish the collection. See California Revenue and Taxation
Code, Division 1, Part 5, Chapter 2.1 Collection in Equal Installments [2700-2708]. This timeline suggests
California municipal governments are unlikely to use advanced property tax payments to finance services at the
beginning of a fiscal year. They are unlikely to recognize the next year’s property taxes as current year’s revenue in
their financial statements, either. This eliminates the concern that these municipal governments’ previous year-end
net positions (or general fund balances) include current year’s property tax revenues.

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FIGURE 1
City of San Diego’s General Fund Cash Flows, Fiscal Year 2013 ($’000)

Data source: [Link]

GOVERNMENT DEBT FINANCING AND MUNICIPAL SHORT-TERM

BORROWING

If a government is running short on cash, it can increase liquidity by issuing certain types of
municipal securities. Municipal securities include “a bond, note, warrant, certificate of
participation or other obligation issued by a state or local government or their agencies or
authorities” according to the Municipal Securities Rulemaking Board (MSRB).2 When
municipal securities qualify for federal income tax exemption—interest or other investment
earnings on them are excluded from gross income of the investors (bondholders)—the issuing
government usually can borrow at lower interest rates than taxable corporate securities. By the
fourth quarter of 2015, the U.S. state and local governments had accumulated outstanding
municipal securities of over 2.96 trillion dollars, equal to 16.5 percent of U.S. gross domestic
product (Federal Reserve Board of Governors 2016).
The majority of municipal securities issued by subnational government are in the form of
bonds. Bonds are characterized by their long-term maturity schedules. A typical long-term bond
matures in more than 15 years from issuance. Governments generally issue bonds to finance
capital investments. Financing capital investment with bonds has its advantages. Many capital
assets are high-priced items. Using the alternative pay-as-you-go (pay-go) approach requires
large initial cash outlays, which may cause a considerable tax rate increase or saving idle cash
(slack) over several years. The pay-go financing approach may also impose an intergenerational
inequity problem with current residents bearing its costs, while future residents enjoying the
benefits. In addition, the pay-go method may cause the over-exhaustion of a tax base in the asset

2. Source: “Glossary of Municipal Securities Terms” The Municipal Securities Rulemaking Board. Updated
August 2013. Source: [Link] (Accessed on April 4, 2016).

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FIGURE 2
City of San Diego’s End-of-Month General Fund Cash Balances, Fiscal Year 2013 ($’000)

Data Source: [Link]

acquisition or construction period. Therefore, capital assets are usually financed through debt that
matches the life range of the assets.
Notes are distinguished from bonds by their short maturity length. Notes usually mature in
one year or less, although sometimes notes with longer maturities are also issued. Notes are
issued when the liquidity is low and repaid when available cash balances are expected to be
strong. Governments issue notes primarily for cash management purposes—to offset the
temporary cash deficit caused by the mismatched revenue and expenditure schedules. Such notes
are called cash management notes, including grant anticipation notes (GANs), tax anticipation
notes (TANs), revenue anticipation notes (RANs), and tax and revenue anticipation notes
(TRANs). Governments also issue notes to provide interim financing for long-term capital
investment projects. These notes are generally in the form of bond anticipation notes (BANs),
construction loan notes (CLNs), or other forms of commercial papers (CPs). In this paper, we
focus on cash management notes only since the research interest of the study is municipal
governments’ cash management strategies.

FINANCIAL SLACK: AN ALTERNATIVE CASH MANAGEMENT TOOL

In the management literature, researchers consider financial resources raised from security
issuances as the external financial resources; and the internal financial resources often refer to
cash, investment income, and other fungible resources firms hold (Myers and Majluf 1984;
Baskin 1989; Goyal and Frank 2008). In the government context, the external financial resources
are those raised from government debt issuances, and the internal financial resources refer to
financial slack a government has accumulated. Slack is a concept that appears in various fields of
disciplines. In general, slack is defined as the excess resources available to an organization,
including excess liquidity, redundant employees, unused capacities, discretionary capital
expenditures, and public services provided in excess of those required (Cyert and March 1963).

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Researchers classify slack as non-financial slack and financial slack. Financial slack is slack
resources that are accounting based and can be measured objectively (Mishina, Pollock, and
Porac 2004; Bradley, Shepherd, and Wiklund 2011). In this study, we focus on financial slack
because it is visible, measurable, accessible, and manageable.
Financial slack occurs quite often in sub-national governments. For the majority of sub-
national governments in the United States, one primary feature of their budgeting and financial
management is the balanced budget requirement. In reality however, governments’ actual
revenues and expenditures rarely equal their budget forecast. In a fiscal year, if a government’s
actual revenues exceed actual expenditures, the excess of revenues over expenditures becomes
financial slack. The forecast errors in budget are difficult to avoid due to the long period between
budget preparation and implementation. Many governments begin their budget preparation
six months before the start of a new fiscal year, some even earlier (e.g., 12 months). During this
period, there inevitably involves some degree of errors that cause the actual revenues or
expenditures to deviate from the budget forecast. For example, revenue collections depend on a
number of factors such as economic condition, population growth, employment, intergovern-
mental aid policies, to name just a few. Each of these factors is subject to change and is difficult to
forecast accurately. Expenditure forecast is also based on many factors out of the control of
management. Planned activities may not take place. A natural disaster may cause a large increase
in unexpected spending. These errors are random and unintentional. Budgeters and government
officials sometimes build slack into budget forecast intentionally. Researchers find evidence of
systematic revenue underestimation and expenditure overestimation in state and local
governments (Rodgers and Joyce 1996; Voorhees 2006; Williams 2012). They call this
budgeting strategy the “conservative forecasting bias” (Mushkin and Lupo 1967; Rose and Smith
2012). The conservative forecasting biases together with the random forecast errors explain why
financial slack often occurs in sub-national governments.
When financial slack occurs, some governments establish formal funds, such as rainy day
funds, budget stabilization funds, or other types of reserve funds to keep their financial slack.
Almost all state governments in the U.S. have established at least one of such funds to keep all
or a proportion of their financial slack (Thatcher 2008). Unlike state government, the majority
of municipal governments do not have formally established reserve funds. Marlowe (2012)
surveyed 27 large cities and found that only 11 of them had a formal rainy day fund. Lacking a
formally established rainy day fund or stabilization fund does not mean that these municipal
governments have no financial slack. Many local governments maintain considerable amount
of slack in their fund balances (Marlowe 2005; Hendrick 2006; Stewart 2009; Wang and Hou
2012; Wang 2015). Fund balance is the difference between a government’s current assets and
current liabilities at the end of a fiscal year, reflecting what is left after the fund’s assets have
been used to meet its liabilities. Traditionally, state and local governments report financial
statements arranged around a series of funds in their Comprehensive Annual Financial Reports
(CAFRs). Each fund is a self-balancing account that records specific aspects of a
government’s financial activities. The number of funds a government operates varies. In
general, there are three major categories of funds: governmental funds, proprietary funds, and
fiduciary funds. Proprietary funds report activities that are operated on a business-like basis,

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such as an airport owned by a government. Fiduciary funds contain resources that the
government holds for others; thus, money in fiduciary funds belongs to the ultimate recipients,
not the government holding it. Governmental funds account for everything else, and they are
the typical funds operated by most governments. Five funds are included in the governmental
funds: general fund, special revenue funds, capital projects funds, debt service funds, and
permanent funds. Among them, the general fund often receives the most attention and scrutiny
from elected officials, citizens, credit rating agencies, and capital market analysts because it is
where most basic and important public services can be found, such as police and fire, sanitation,
social services, and so on. Some small municipal governments report all transactions in the general
fund.
Governments that follow the Generally Accepted Accounting Principles (GAAP) report
their general fund balances as reserved and unreserved fund balances. Reserved general
fund balances report resources legally limited for particular purposes such as debt service
and capital replacement. Therefore, the reserved general fund balance is not financial
slack. If the general fund balance carries no restrictions on its future use, it is called
unreserved general fund balance. The unreserved general fund balance (UFB) offers
government officials available financial resources under their management discretion;
thus, it is a proper financial slack measure. In addition, the general fund balance is reported
on a modified-accrual basis of accounting that focuses on short-term or in other words,
liquid financial resources. Therefore, the UFB reflects a government’s available and liquid
financial resources for operations. For the above reasons, we use the UFB to measure
municipal governments’ financial slack.

THE PECKING ORDER THEORY AND GOVERNMENTS’ PREFERENCES OVER

FINANCIAL RESOURCES

The Pecking Order Theory and Its Applications

The pecking order theory is one of the dominant theories that explain firms’ capital structure
choice. This theory suggests that firms prefer internal to external financing; if external
financing is required, firms issue the safest securities first such as risk-free or less risky bonds,
then hybrid securities such as convertible bonds, and lastly the common stock (Myers 1984;
Myers and Majluf 1984). The pecking order theory predicts that firms follow a preference
ranking over financial resources: internal funds first, followed by debt, and then equity.
Researchers use information asymmetry to explain firms’ pecking order preference. Managers
and owners of a firm know the true value of the firm’s assets and growth potential because
they often have the inside information and organizational knowledge. Investors can only guess
these values. In most cases, managers of overvalued firms are motivated to sell equity whereas
managers of undervalued firms will not. This suggests a potential adverse selection problem in
the corporate stock market (Leary and Roberts 2004; Goyal and Frank 2008). If a firm offers to
sell equity when investors know the firm does not have to, investors may view this attempt as a

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negative signal regarding the quality of the equity and the value of the firm (Myers and Majluf
1984; Baskin 1989). Therefore, firms prefer internal financing the most because using internal
funds avoids the adverse selection problem. Agency costs can also explain firms’ pecking
order behavior (Myers 2003). The agency theory argues that if managers search for external
financing, they have to explain project details to outside investors and keep administration
more transparent. This unavoidably exposes themselves to investors’ monitoring. Managers
dislike this process and therefore they prefer using internal financial resources (Goyal and
Frank 2008).
The competing theory that explains firms’ capital structure choice is the static trade-off theory.
The trade-off theory describes a family of related theories assuming that firms seek an optimal
capital structure through a tradeoff between the tax advantages of issuing debt and the costs of
financial distress when the debt burden is too high (Modigliani and Miller 1958). A value-
maximizing firm seeks to maintain a capital structure that the marginal costs of debt equal its
marginal benefits. This theory predicts that firms have target capital structures and they adjust
gradually toward an optimal debt ratio.
Neither the trade-off theory nor the pecking order theories could tell a full story of
organizations’ capital structure and their financial decision-making (Leary and Roberts 2010).
Nevertheless, some researchers find that the pecking order is “a much better first-cut explanation
of the debt-equity choice” (Shyam-Sunder and Myers 1999, p. 221), and the pecking order is a
good descriptor of firms’ financial behavior (Titman and Wessels 1988; Shyam-Sunder and
Myers 1999; Leary and Roberts 2004; Lemmon and Zender 2010). In Leary and Roberts’ recent
study, they find that 77 percent of the firms in their sample follow the pecking order in choosing
between internal and external financing (Leary and Roberts 2010). Researchers in nonprofit
studies apply the pecking order theory in the nonprofit sector and they find evidence that
nonprofit organizations also follow a pecking order of preference over financial resources:
internal funds are preferred over external borrowing (Bowman 2002, Denison 2009, Yan,
Denison, and Butler 2009, Calabrese 2011).
The pecking order theory is traditionally used to solve organizations’ capital structure
puzzle. Since capital structure puzzle refers to long-term financial issues mostly, it is fair to
say this theory is often used to explain organizations’ long-term financial choices. However,
we believe the pecking order theory has the potential to solve the cash management puzzle,
that is, organization’s short-term financial choices. The pecking order theory is about choice
between using internal funds and external financing. Whether in the case of capital structure
choice or cash flow management, managers face the choice of using retained earnings or
borrowing. In the former case, borrowing refers to issuing long-term bonds; in the latter case,
borrowing refers to issuing cash management notes. In this study, we use the pecking order
theory to examine whether municipal governments prefer internal financing (i.e., using
financial slack) to external financing (i.e., issuing cash management notes) when managing
their cash flows. This paper presents the first known study that uses the pecking order theory to
explain governments’ cash management strategies. It is also the first known study that extends
the application of pecking order theory from firms and nonprofit organizations to municipal
governments.

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A Model of Municipal Short-term Borrowing
Based on the pecking order theory, we develop a model that incorporates municipal short-term
borrowing as the dependent variable, municipal financial slack as the independent variable, and a
number of control variables. We use the amount of cash management notes issued in the current
fiscal year by an individual municipal government as a percentage of its total operating
expenditures to measure municipal short-term borrowing (labeled as Notei;t ). We use unreserved
general fund balance as a percentage of its total operating expenditures to measure municipal
financial slack (labeled as Slacki;t ). We lag Slacki;t by one year to reflect a city’s beginning-of-
year financial slack level (labeled as Slacki;t1 ). We hypothesize that government officials make a
deliberate choice between using financial slack and issuing notes. They prefer financial slack and
will turn to short-term borrowing only when slack is not sufficient for their cities’ cash flows. The
amount of beginning-of-year financial slack affects both whether and how much a city issues
cash management notes.

Hypothesis: Beginning-of-year financial slack reduces both t likelihood of using short-term

borrowing and amount of current-year notes issuance by municipal governments.

The model also incorporates several control variables that are hypothesized to affect a city’s
dependence on short-term borrowing, including a municipal government’s institutional, fiscal,
demographic characteristics as well as some key features of the notes, and local economic
condition indicator. The overall structure of the model is:

Notei;t ¼ f ðSlacki;t1 ; Fiscal PolicySpace i; t ; Fiscal Structural Factorsi;t ;

City Sizei;t ; Note Featuresi;t ; Economic Conditionm;t Þ

A government’s fiscal policy space refers to the freedom government officials can operate,
decide, and create fiscal policies; in other words, how many options or tools government officials
can use to solve financial problems (Pagano and Hoene 2010). Municipal governments’ fiscal
policy space is usually determined by their state governments’ restrictions on local fiscal policies
(Hendrick and Crawford 2014). The most common restrictions are tax and expenditure
limitations. For example, in California, the passage of Proposition 13 in 1978 changed local
governments’ fiscal policy space. It shifted the control of property taxes from local to state
government through the change of property value assessment authority and property tax revenue
allocation. Any new special tax from local governments must be passed by a two-thirds vote of
the electorate (Hoene 2004). These limitations however, may not apply to municipalities that
have adopted a city charter. The California State Constitution allows cities to adopt city charters
that authorize them more fiscal policy space. Compared to the general law cities, charter cities
have broader assessment power and taxing power such as to impose real property transfer tax.
They have supreme authorities over local expenditures, land use and zoning decisions, and

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municipal contracts. They also have the freedom to choose forms of government, methods of
elections, voting requirements, personnel matters, and among others.3 As of July 1, 2011, among
the 482 incorporated cities in California, 121 cities are charter cities, and the rest are general law
cities.4 We use the variable Charter Cityi;t to approximate fiscal policy space. This variable is
coded 1 if a municipal government is a charter city in a particular fiscal year; 0 if it is a general
law city. We hypothesize that charter cities are more likely to issue notes considering their greater
fiscal freedom. However, the charter status may not affect the amount of note issuance because
how much notes a city needs depends on the city’s financial condition, needs in liquid financial
resources, and cash management strategies, not the charter status.
A government’s fiscal structure denotes its key financial characteristics, such as revenue
sources, tax burden, debt structure, levels of fund balance, and so forth (Hendrick and Crawford
2014). To capture the impacts of fiscal structure on municipal governments’ short-term borrowing,
we include five fiscal structure factors in the model. The first indicator is dependence on
intergovernmental revenues. Financial professionals and researchers consider over-dependence on
intergovernmental revenues a risk factor in local finance because the amount of aid from state and
federal government and the time of aid disbursement are not under municipal government’s control
(Bowman, Calia, and Metzgar 1999; Hendrick 2006). To make things worse, state governments
often reduce the amount of aid or delay aid disbursements during economic recessions when local
governments are in greater need of such revenues. Dependence upon intergovernmental revenues
adds uncertainty to local revenue forecast and sometimes creates cash flow problems, suggesting
that municipal governments with greater dependence on intergovernmental revenues need more
liquid financial resources to manage cash flows. We use revenues received from state and county
governments as a percentage of total municipal revenues to measure this variable, and label it
IG Revenuei;t . We hypothesize that dependence on intergovernmental revenues increases both the
probability and the amount of municipal short-term borrowing.
The second indicator is revenue diversification calculated by a reversed Herfindahl-
Hirschman Index based on five primary own-source general revenues: property taxes, sales and
transient lodging taxes, franchises and business license taxes, real property transfer taxes, and
other taxes (including utility user tax, construction development taxes, and admission taxes).5
The value of this index ranges from 0 to 1 with increasing values indicating greater revenue
diversification. Effective revenue diversification creates stable revenue streams (Carroll 2009),
hence reducing municipal governments’ need in using short-term debt to manage cash flows.
Certain spending categories may increase cash flow problems. For example, the amount of
debt service expenses is not part of the annual appropriation process because it was pre-set at the
point of bond issuance. Government officials have no administrative authority to change,

3. Source: “General Law City v. Charter City” League of California Cities. [Link]
Documents/Resources-Section/Charter-Cities/Chart_General_Law_v-_Charter_Cities-07-26-11 (Accessed on
April 4, 2016).
4. “Charter City List” League of California Cities. [Link] (Accessed on
X5
April 4, 2016). 1 R2
j¼1 j
5. We use this formula to calculate the Herfindahl-Hirschman Index: RD ¼ 1 1 .
5

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especially to reduce debt service spending. This constrains their ability to use spending
adjustment to address cash flow problems. We include Long-term Debt Service Expensesi;t
measured as expenditures on long-term debt principal retirement, interests, and other financial
charges as a percentage of total municipal operating expenditures in the model. Employee payroll
requires biweekly or monthly disbursement, representing one major cash outflow in local
government. Governments with greater salary burden face greater challenge in in balancing their
cash flows. We include Salary Burdeni;t measured as salary expenditures as a percentage of total
municipal operating expenditures in the model. We expect these two expenditure categories to
increase a city’s short-term borrowing. The last fiscal structure factor is Debt Burdeni;t measured
as per capita long-term debt outstanding. We hypothesize that greater long-term debt burden
restrains municipal short-term borrowing.
The size of a city may affect its access to the municipal securities market, as smaller cities sometimes
face more restrictions on debt issuance. City size is also associated with the independent variable
—Slacki;t . Studies have found that larger cities generally maintain less financial slack (Hendrick 2006;
Marlowe 2012), suggesting that they may need more external financial resources for cash flows.
Municipal revenues and expenditures tend to move with the ebb and flow of local economic
activities. To capture the impacts of local economic condition on municipal financial
management, we use the unemployment rate of the county where a city locates to control for the
general economic condition. The model also includes note interest rate charged on a particular
transaction to capture the cost of short-term borrowing.

DATA SOURCES, SAMPLE DESCRIPTION, AND METHODOLOGY

Data Sources and Sample Creation

We test this model using a sample of cities in California. We chose California cities to study this
subject for three reasons. First, California is among those states where local governments actively
issue notes for cash management purpose. Second, California is among the very few states that
releases its local governments’ short-term debt issuance information. Third, California has the
largest population and economy in the United States, making this study significant even though it
is not a nationwide study. In addition, the California Constitution gives its cities the authority to
become charter cities. This provides an opportunity to examine how institutional factors (i.e.,
fiscal policy space) affect municipal governments’ financial options.
We compile information from various sources. The two primary data sources are the
California Debt and Investment Advisory Commission (CDIAC)’s Debt Issuance Database and
the California State Controller’s website. California state law requires that all governmental
agencies that issue debt should report information on each issuance to the CDIAC.6 In 2006, the
CDIAC launched a publicly accessible database that includes comprehensive information on

6. Source: “Government Code 8855(k) and 8855(i)” State of California Lenitive Counsel. [Link]
gov/cgi-bin/displaycode?section=gov&group=08001-09000&file=8855-8859 (Accessed April 4, 2016).

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bonds, notes, and other public debt sold or issued by the State and all of its local government
agencies. Data are available from 1984 to present, and is updated monthly. We consider the
CDIAC’s data better than other alternative data sources to study local short-term borrowing. For
example, the Census Bureau’s Local Government Finance database reports the year-end note
outstanding. However, most of the notes are paid off within 12 months. Hence, the year-end note
outstanding does not tell much about the amount of notes issuance during the year, but rather
the amount of outstanding notes that are carried to the next fiscal year. The note issuance
information reported in the CDIAC’s database provides a much more accurate measure of
municipal short-term borrowing in a particular fiscal year.
The CDIAC’s Debt Issuance Database does not report municipal revenues, expenditures, assets,
liabilities, fund balances, and other financial information. We obtain such information from the
California State Controller’s open data website. Cities in California are required by law to report their
financial data in paper format to the Controller within 90 days after the close of the fiscal year, or in the
required electronic format within 110 days. The Controller’s office reviews, compiles, and publishes
the annual financial transaction reports. We obtain the list of California charter cities from the League of
California Cities’ website, municipal population information from California Department of Finance’s
website, and the county level unemployment rates from the Bureau of Labor Statistics’ website.

Sample Selection and Selection Bias

We include all but four California cities in the sample. The four cities are left out either because they
were incorporated after 2010, or there is obvious data error or missing data.7 Due to the change in
definition of unreserved general fund balance (UFB) required by GASB Statement No. 54, we restrict
the time span of the sample between fiscal years 2003 and 2011 to avoid potential measurement
inconsistency on fund balance. Regarding notes issuances, we restrict the sample to include only cash
management notes, excluding all other types of notes such as projects notes, notes for single or multiple
family housing, equipment, utility, and among other purposes. Among the 478 California cities, 420
cities (or 88 percent) have never issued any cash management notes during the study period. The
majority of cities that have ever issued notes are non-frequent issuers. Only five cities (or 8.6 percent of
all issuer cities) issue cash management notes every year. Table 1 presents the frequency of notes
issuances among those issuers between fiscal years 2003 and 2011.
The fact that a large number of cities never issued notes raises a concern of potential selection
bias in the sample. Sample selection bias arises when a researcher does not observe a random
sample of a population of interest. In other words, observations on the dependent variable are not
missing randomly, but conditional on some variables. One such example is the effect of
education on women’s wages where the dependent variable can only be observed when an
individual female participates in the labor market. Without any correction, samples with
selection bias often lead to inconsistent estimators and biased inferences (Heckman 1979).

7. These four cities are City of Jurupa Valley (incorporated on July 1, 2011), City of Eastvale (incorporated on
October 1, 2010), City of Escalon (multiple years of negative general fund operating expenditures), and City of Paso
Robles (key financial information is missing).

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TABLE 1
The Frequency of Cash Management Notes Issuance, FY2003FY2011
Total number of notes issuances
Frequency of note issuances Number of cities Percent (Column 1 Column 2)
1 17 29.3 17
2 12 20.7 24
3 5 8.6 15
4 5 8.6 20
5 5 8.6 25
6 3 5.2 18
7 3 5.2 21
8 3 5.2 24
9 5 8.6 45
Total 58 209

Similarly, in this study, observations on the dependent variable (i.e., Notei,t) can only be observed
if a city issued cash management notes. The issuance of notes by these cities is not random, but
depends on several factors. For example, in California, charter cities have more fiscal options
when addressing financial problems, such as issuing notes. They may not need to accumulate as
much financial slack to manage cash flows as the general law cities do. This will affect their need
in short-term debt financing. It is also reasonable to expect that cities facing greater fiscal stress
are more likely to issue cash management notes. To compare whether cities that issued notes
differ significantly from those that did not, we conduct a two-sample t-test over some key
municipal characteristics variables. Results in Table 2 show that cities that issued cash
management notes are more likely to be charter cities, have less financial slack, with more
diversified revenue sources, with greater share of salary expenditures and long-term debt service
expenditures, and have larger population. This suggests that selection bias exists in this sample.

Heckman Selection Model

Researchers often use the Heckman selection model to correct sample selection bias. The
Heckman selection model is a type of Tobit model that treats selection bias as omitted variable
bias. The first stage of this model is to create a selection equation and estimate the probability that
a city would issue notes. At this stage, a statistically adjusted value (inverse mills ratio) is
calculated for each observation based on the expected error from the selection equation. In the
second stage, the model includes the inverse mills ratio as an explanatory variable to examine
whether financial slack reduces the amount of notes issuances. The results—the Heckman
estimators—are thereby adjusted for self-selection bias (Heckman 1979).
Variables used in the first stage selection model include: Slacki,t1, Charter Cityi,t, IG
Revenuei,t, Revenue Diversificationi,t, Salary Burdeni,t, Long-term Debt Servicei,t, Expenses,
Debt Burdeni,t, Log Populationi,t and Unemployment Ratem,t. We expect these variables to affect

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TABLE 2
A Comparison of Cities With and Without Notes Issuance
Mean

Cities with note Cities without note

Variable issuance issuance Difference t-statistics
Charter city 0.49 0.24 0.25 8.15
Financial slack 9.52 41.19 31.67 8.81
Intergovernmental revenue 5.35 6.28 0.92 1.51
Revenue diversification 0.79 0.73 0.05 5.33
Salary burden 39.88 32.54 7.34 8.86
Long-term debt service 4.12 2.47 1.65 7.60
expenses
Debt burden 80.48 846.33 765.85 0.261
Population 337,841 48,887 288,953 21.68
Note: significance levels are indicated as  p < 0.05  p < 0.01 
p < 0.001 (2-tailed).

a city’s probability to issue cash management notes. The second stage estimation model includes
all variables in the first stage except Charter Cityi;t . A city charter may influence a city’s access to
the municipal securities market, and hence its probability to issue notes. However, it does not
necessarily determine how much notes a city issues. The financial condition of a city and its need
for liquid financial resources are more likely to affect the amount of notes issuance. The second
stage model also includes one variable that is not included in the first stage equation—note
interest rate (Note Interesti;t ).8 Note Interesti;t is a variable that only exists among those observed;
thus it cannot be used as a predictor of notes issuance in the first stage model. We include
Note Interesti;t in the second stage model because borrowing costs affect the amount of
borrowing. This is especially common in capital market when governments borrow
opportunistically by taking advantage of low interest rates. Sometimes, governments determine
interest rate simultaneously with the issue amount, suggesting note interest rate might be an
endogenous control variable. We checked the endogeneity issue possibly caused by simultaneity

8. The note interest rates reported in the CDIAC database are either calculated based on net interest cost (NIC) or
true interest cost (TIC). The CDIAC dataset does not have sufficient information to convert all interest rates into a
uniform one. TIC and NIC are similar, except that TIC takes into account the time value of money. The longer it takes
for a bond to mature, the more interest payment periods are involved, and the greater difference between TIC and
NIC. In recent years, TIC interest rates are gaining more popularity among researchers as a proper measure of bond
costs (Hildreth and Zorn 2005). The difference between TIC and NIC can be significant for long-term bonds. In our
study, most notes mature within a year, and interest is payable at maturity without redemption prior to maturity. The
short maturity length and single interest payment period indicate that conceptually, the difference between NIC
interest rate and TIC interest should be negligible. A few cities reported both NIC and TIC interest rates in the CDIAC
database in Fiscal Year 2012. These cases confirm our assumption that the differences between the two interest rates
are subtle. Therefore, the lack of uniform interest rate does not bias the results in this study.

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by examining the correlation between Note Interesti;t and the dependent variable. Results
alleviate our endogeneity concern: the correlation coefficient between the two variables is
negligible (r ¼ 0.0519), and the correlation is not statistically significant.

FINDINGS

During this nine-year period, 58 California cities issued 209 cash management notes. Nine cities
issued notes more than once within a fiscal year. For data analysis purpose, we consider multiple
note issuances within a fiscal year as one issuance, taking the sum of multiple principals as the
total principal, and the weighted average interest rate as the interest rate, and the weighted
average maturity length as the maturity length. The majority of these notes are tax and revenue
anticipation notes (TRANs). Most of these notes are paid by general fund revenues. Negotiated
sale is the dominant way of notes sales, and most cities choose net interest costs (NIC). Among
cities that issued cash management notes, the mean average amount of principals issued by an
individual city in a fiscal year is 58.5 million dollars, with the smallest principal amount of
250,000 dollars and the largest principal amount of 1.26 billion dollars. The mean average
interest rate for these notes is 2.29 percent. On average, these notes matured in 366 days, with the
shortest maturity length of 49 days, and longest mature length of 411 days. Table 3 presents
detailed descriptive statistics of these notes.
The pecking order theory predicts that managers prefer internal funds to external funds, and
hence financial slack reduces a city’s need of short-term borrowing. We use a Heckman selection
model to examine the impact of beginning-of-year financial slack on municipal cash
management notes issuance. All coefficients are robust estimators obtained by using the cluster
option that specifies to which group (i.e., city) each observation belongs. This cluster option
relaxes the usual requirement of independent observations—observations are independent across
groups (clusters) but not necessary within groups. We include time fixed effects in the second
stage model to capture the influence of aggregate trends. Table 4 reports Heckman estimators and
the associated robust standard errors and z statistics.
The coefficients on beginning-of-year financial slack are negatively significant at both stages,
suggesting that financial slack not only lowers a city’s probability to issue cash management
notes, but also reduces the principal amount of the notes issued in a fiscal year. The second stage
coefficient on beginning-of-year financial slack shows that when unreserved general fund
balance (the UFB) as percentage of total operating expenditures increases by ten percentage
points, the principal amount of notes as percentage of total general fund revenue decreases by
1.93 percentage points. We need to point out that this causal claim is somewhat weakened by the
existence of recursive borrowing. Recursive borrowing happens when cities use short-term
borrowing as a regular cash management strategy—each year they issue notes to cover cash flow
deficits and pay off the short-term debt when anticipated revenues come in. By doing so, these
cities deliberately keep financial slack low at fiscal year-end. In cases of recursive borrowing, low
financial slack is no longer the cause of short-term borrowing but its result, suggesting a possible
reverse causality that contaminates the causal claim.

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TABLE 3
Descriptive Statistics of Notes Issuance by California Cities, FY2003FY2011
Median Mean Std. Dev. Min Max
Principal amount (million $) 6.36 58.5 182 0.25 1,260
Interest rate (%) 1.95 2.29 1.37 0.08 9.00
Maturity length (days) 379 366 50 49 411

Frequency Percent Cumulative

percent
Forms of notes
Tax and revenue anticipation notes (TRANs) 206 98.56 98.56
Tax anticipation notes (TANs) 2 0.96 99.52
Revenue anticipation notes (RANs) 1 0.48 100.00
Repayment sources
General fund revenues 205 98.09 98.09
Property tax revenues 3 1.44 99.53
Intergovernmental transfers 1 0.48 100.00
Sales types
Competitive sales 48 22.97 22.97
Negotiated sales 161 77.03 100.00
Interest types
Net interest costs (NIC) 135 64.59 64.59
True interest costs (TIC) 69 33.01 97.61
Variable interest rates 5 2.39 100.00

To examine to what extent recursive borrowing weakens the causal claim, we analyze the
pervasiveness of recursive borrowing in the sample. We consider recursive borrowing has two traits.
The primary trait is the frequency of notes issuance—those who borrow frequently (especially those
that borrow annually) are more likely to be recursive borrowers. Table 1 shows that only five cities
issued notes annually during the nine-year study period.9 The majority of municipal issuers issued
notes occasionally. A secondary trait of recursive borrowing is the consistency of issue amount. We
examine the annual change rates of principal amounts among the five most frequent issuers. The
average annual change rate of principal amounts is 8.7 percent with a standard deviation of 27.5
percent, suggesting considerable fluctuations in issue amounts among the five most frequent issuers.
In all, the analysis shows that recursive borrowing exists in the sample, but it is not pervasive. The
existence of recursive borrowing indeed weakens the causal claim of the findings; nevertheless, the
basic causal findings still hold since recursive borrowing is not pervasive. We conduct a robustness
test by running the model excluding the five most frequent issuers. The consistent results confirm our
assessment of recursive borrowing’s impact on the causal findings.

9. These five cities are Berkeley, Los Angeles, Oakland, San Diego, and Selma.

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TABLE 4
Heckman Estimators on Notes Issuance
Coefficient Robust Std. Err. Z statistics
Second stage
Financial slack (beginning of year) 0.193 0.072 2.67
Intergovernmental revenue 0.001 0.121 0.01
Revenue diversification 0.920 9.410 0.10
Salary burden 0.364 0.114 3.19
Debt burden 0.002 0.003 0.83
Long-term debt service expenses 0.597 0.256 2.34
Note interest rate 0.267 0.688 0.39
Log of population 0.749 1.231 0.61
(Results of year dummies omitted)
First stage (selection model)
Financial slack (beginning of year) 0.022 0.004 5.27
Charter city 0.126 0.101 1.25
Intergovernmental revenue 0.001 0.009 0.17
Revenue diversification 0.806 0.587 1.37
Salary burden 0.021 0.006 3.28
Debt burden 0.000 0.000 0.15
Long-term debt service expenses 0.032 0.020 1.62
Log of population 0.245 0.073 3.38
Unemployment rate 0.029 0.016 1.82

Number of Obs. 3,761

Censored Obs. 3,579
Uncensored Obs. 182
Rho 0.969
Sigma 11.687
Lambda 11.330
Wald Chi2(15) 66.11
Note: significance levels are indicated as  p < 0.05  p < 0.01 
p < 0.001 (2-tailed).

The statistically significant coefficients on salary expenditures at both stages and the
significant coefficient on long-term debt service expenses at the second stage suggest that salary
and long-term debt service expenses increase municipalities’ need for short-term borrowing. On
average, when a city’s salary expenses as share of total operating expenditures increases by ten
percentage points, the principal amount of notes as share of total revenue rises by 3.6 percentage
points. When a city’s debt interest payment as share of total general fund operating expenditures
increases by ten percentage points, the principal amount of notes as share of total revenue rises by
about six percentage points. These findings provide evidence to support organization theorists’
argument that non-discretionary expenditure categories restrict a city’s financial management
flexibility thereby increasing its dependence on short-term borrowing.

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The coefficient on the natural logarithm of population is positively significant only at the first
stage, suggesting that larger cities are more likely to issue cash management notes, but the size of
a city does not necessarily influence how much cash management notes it needs. The coefficients
on charter cities are not significant at either stage. This suggests that issuing cash management
notes is not a financial management choice specifically associated with charter cities. There is
no obvious difference between charter cities and the general law cities regarding the use of
short-term borrowing to manage cash flows.

CONCLUSION

This paper examines factors that affect municipal governments’ short-term borrowing decisions,
particularly the role of financial slack. The finding that financial slack reduces both the
probability and the amount of notes issued by municipal governments supports the pecking order
theory’s claim: when both internal financial resources (financial slack) and external financial
resources (short-term borrowing) are available, government financial officers prefer internal
financing to external financing. This finding has significant implications for our understanding of
public officials’ financial decision-making. Our study extends the application of pecking order
theory from firms and nonprofit organizations to municipal governments, suggesting the
applicability of this theory in future public financial management research.
The paper also finds certain spending categories such as long-term debt service expenses and
salary burden increase a city’s dependence on short-term borrowing. This finding suggests that
cities that attempt to reduce their dependence on short-term borrowing in managing cash flows
can consider increasing financial slack as an alternative approach. This finding provides an
explanation of government slack accumulation in addition to organization theory’s risk-slack
hypothesis. Organizational theorists consider slack as a cushion against risks and they argue that
organizations exposed to more risk factors need more of such a cushion to buffer against risks and
uncertainties (Cyert and March 1963; Bradley, Shepherd, and Wiklund 2011). Results from this
study shows that besides preparing for potential risks, municipal governments accumulate
financial slack to reduce their dependence on short-term borrowing.
In all, this study demonstrates the efficacy of financial slack in local governments. It is an important
counter-cyclical expenditure stabilization device (Marlowe 2005; Wang 2015). It improves local
governments’ credit worthiness (Marlowe 2011). It also serves as a convenient cash management tool,
reducing municipal governments’ dependence on short-term borrowing. Results from this study to
some extent provide justification of government slack accumulation as a precautionary management
strategy. This study improves our understanding of the roles financial slack plays in subnational
government. Yet our understanding of government slack accumulation remains a tremendous gap,
regarding the rationale, the optimal level, and the impacts. Our study is limited to a single state. If data
are available, future studies should examine local governments across states. Another limitation is that
this study primarily examines the impacts of municipal fiscal structural factors, without paying much
attention to those political, managerial, and organizational factors. The fiscal policy space variable—
charter city—captures some of the political variations because charter cities have greater political

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authorities such as the freedom to choose forms of government, methods of election, voting
requirements, and among others. Nevertheless, this dummy variable cannot capture the nuance of the
impacts of particular political factors on municipal financial decision-making. Future research should
overcome this limitation as well.

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