Accounting for the State Fixed Effect for Municipal Cash Reserves: The Role of Financial and Institutional Variables

Abstract

One of the most important predictor variables in multistate studies of American municipal cash reserves is the state in which a municipality is located, and to date no research has explored why. In this paper, we show that two broad categories of variables can account for a large fraction of this puzzle. Average differences in financial variables and state-to-state institutional differences combine to absorb over 80% of the importance of state fixed effects, with financial variables mostly accounting for why cities in some states save less than the national average, and institutional variables doing a better job of accounting for why cities in some states save more than the national average.

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“…We augment these tests with several important sensitivity analyses. Considering the importance of state fixed effects for municipal cash reserves (Pierson et al, 2022), we also run our tests of the bandwagon effect with an inverse distance weighted average of cash reserves composed only of cities in different states. While we do not expect that this test will be a good representation of the most likely role models selected by municipal financial managers, it does allow us to test for whether being in the same state is the sole driver of the geographical effect we expect to detect.…”

“…This could be caused by heuristics since savings decisions driven by anchoring on either past savings levels or the behaviors of one's neighbors would manifest as a stubborn persistence in the average level of savings for municipalities within a geographic area. While these patterns might also be explained by culture, finance, or government structure (Gorina, 2013; Hendrick, 2006; Wang, 2017), in practice even a kitchen‐sink approach to including control variables can only explain part of the importance of state fixed effects (Pierson et al, 2022).…”