Debt incentivised income smoothing in Polish municipally-owned companies

PurposeThis paper examines the sensitivity of Polish municipally-owned companies’ (MOCs’) income-smoothing behaviour to leverage compared to private firms, considering leverage distribution and types of municipal ownership. On the one hand, local governments (LGs) with limited fiscal autonomy may use unconsolidated MOCs to bypass budgetary constraints. Such off-budget financing may incentivise income smoothing to meet debt covenants and reduce financing costs. On the other hand, those MOCs under public owners’ guarantees face soft budget constraints and potential bailouts. Therefore, they can be less motivated to make a smooth income. We intend to identify which motive prevails.Design/methodology/approachThe study analyses MOCs in Poland using GMM and Tobit models on data from over 17,400 firms retrieved from the Orbis database during the period 2010–2022.FindingsResults indicate that MOCs’ smoother income increases the likelihood of borrowings and higher indebtedness. They smooth out income more than private firms above a median of leverage distribution. Overall, MOCs’ income smoothing is influenced by debt ratios, municipal owners’ fiscal autonomy and the electoral cycle.Practical implicationsResults emphasise the need for fiscal oversight and transparency as increased MOCs’ income-smoothing is likely motivated by hiding local public debt, especially under indirect MOCs’ executive authorities elections. This threatens the fiscal stability of financially weak and less autonomous LGs when they guarantee MOCs’ debt.Originality/valueThe findings highlight the unintended consequences of New Public Management reforms, especially when local public services adopt a business-oriented approach to enhance efficiency using private-sector management models. The financial issues MOCs face become the financial responsibility of their owners. However, once their debt reaches a significant threshold, MOCs tend to halt these practices, possibly indicating that local authorities self-regulate when debt levels become concerning, especially in LGs with some fiscal flexibility and where there is greater social control through direct mayoral elections.