Monitoring and Local Governance: Evidence from Italy

Abstract: Monitoring by external auditors is a ubiquitous practice in complex organizations. Frequently, the audited entity appoints the external auditor. While locally-appointed auditors might have better local knowledge, leaving discretion in the hands of the audited party might impair monitoring quality. In this paper, I exploit a unique setting which allows me to evaluate this trade-off in the context of auditing of municipal budgets of local governments. In 2011, Italy introduced a reform that removed the discretion of the appointment of municipal auditors from mayors and introduced a random-assignment system. The objective of the reform was to strengthen monitoring and ensure fiscal sustainability of municipal budgets. I study the consequences of increased monitoring on public finance outcomes of local governments. My identification exploits the staggered introduction of the reform across municipalities in an event-study setting. I obtain three main findings. First, the reform greatly increased compliance with fiscal rules: treated municipalities increase their surpluses by 20% and their debt repayments by 2%. Second, improvements largely come from municipalities in which the mayor was term-limited and from those local governments that were running deficits before the reform. Third, the improvement in compliance with fiscal rules comes at a cost: treated municipalities significantly cut investment expenditures by over 7% and increase local taxes by 8%.