This is outside of my normal software-focused beat, but I met some folks who were very interested in public policy recently. I found, to my surprise, that I probably understand one innovative Japanese tax policy better than very well-informed people who geek out about tax policy [0].

This post hopefully fixes that bug. (Hat tip to gwern for suggesting I write it up.)

Two countries in one border

The Japanese employment market has a curious feature: there are regions of Japan with extremely high economic productivity (such as Tokyo, Osaka, and Nagoya, but for the purpose of this issue think “Tokyo” and you won’t be wrong) and regions with low economic productivity (substantially everywhere else). This counsels that a young person born and educated in e.g. Gifu move to Tokyo after graduation to earn a living.

Many, many do. While Japan’s overall population is declining, Tokyo’s increases by about 100,000 people per year.

The regions in Japan are not thrilled about this state of affairs for many reasons. Tokyo isn’t just the seat of Japanese commerce; it also houses the government, media, cultural institutions, etc etc. There is a real sense that your children moving to Tokyo causes them to lose connection with their culture and that the rewards from the national enterprise aren’t being allocated fairly. Tokyo, for its perspective, views the regions with the noblesse oblige that you would expect a cosmopolitan center of culture and learning to have with respect to their benighted country bumpkin cousins.

(If this sounds like it echoes the political economy of, say, two large English-speaking nations recently, well, folks greatly overestimate how different Western nations are from each other.)

A misalignment in incentives for human capital development

Educating children is incredibly expensive. The regions are quite annoyed that they pay to educate their children but that Tokyo reaps all the benefits. This state of affairs has continued for decades.

But Japan has a policy response for it, and it is sort of beautiful. Called ふるさと納税 (Furusato Nouzei or, roughly, the Hometown Tax System), it works something like this:

A substantial portion of Japan’s income-based taxes are residence taxes, which are paid to the city and prefecture (think state) that one resides in, based on one’s income in the previous year. The rate is a flat 10% of taxed income; due to quirks of calculating this which almost certainly aren’t relevant to you, you can estimate this as 8% of what white collar employees think their salary is.

Furusato Nouzei allows you to donate up to 40% of next year’s residence tax to one or many cities/prefectures of your choice, in return for a 1:1 credit on your tax next year. This is entirely opt-in. Anyone can participate, regardless of where they live.

In principle, the idea is to donate to one’s hometown. Importantly, one actually has unfettered discretion as to which city/prefecture one donates to. This has some very important implications discussed later.

Relevantly to your understanding of the incentives here: most Japanese people do not file taxes every year. Income-based taxes are calculated and remitted by employers directly on the behalf of their employees. Participating in the system requires friction which is somewhat above e.g. changing your direct deposit information but far below e.g. filing a tax return.

What was the idea here?

Tokyo and the regions could have resolved their differences through the democratic process, in which the regions outvote Tokyo and could have altered Japan’s national tax and economic policies to their advantage. Tokyo obviously doesn’t want this, and instead agreed to an opt-in system which allays some of the regions’ concerns.

To the extent that taxpayers donate to their hometowns, Tokyo no longer freerides on the substantial public expenditures required to raise and educate internal migrants.

Putting potentially 40% of Tokyo’s residence tax in play is not a small carrot. Individual residence tax is roughly 45% of the city’s revenue. That works out to roughly $30 billion a year.

Now if you were a negotiator for Tokyo back in ~2006 when this was being debated, you might have thought “Hmm, while this sounds like it is putting $12 billion a year into play, it’s not actually nearly that bad for us. People have to take affirmative steps to transfer the money to their city of choice, and they have to float the money for most of a year, because of the donate-then-credit mechanism. Uptake on that won’t be that high. Maybe we’ll lose a few tens of millions of dollars; no biggie. Silly country bumpkins; can’t even math.”

But after the system was created, city governments started getting really creative. And what happened next is by parts beautiful and crazy.

Incentives rule everything around me

There exists a culture in Japan of reciprocating gifts. While it varies based on where you live, in the areas I’ve lived, the general rule of thumb is 30%: if you give someone $300 cash on the occasion of their wedding, as is customary for gainfully employed people with respect to someone outside their immediate family, they’re socially obligated to find a way to give you $90 of value back. (The mechanisms for doing this could merit their own post; the word is 返礼品. A dictionary translates this as “quid pro quo”, but the sentiment does not match the common English usage of that phrase. This is simply a ritual; to not participate in it would be non-normative.)

While not formally defined in the legislation for the Furusato Nouzei system, someone at a city government figured that it was just not appropriate to let someone just give ~3% of their salary to the city without receiving a token of appreciation in return. So they sent something back; a can of locally-produced plums, say, to remind you of the tastes of your childhood.

And this was a beautiful idea! It directly improved the ability of the system to cement relationships between internal migrants and their hometowns, one of the declared goals of the system. It motivated people to fill out paperwork and float the city a bit of money for part of a year, because who doesn’t like free plums. (You might sensibly object that they aren’t free given the time value of money, but prevailing interest rates in Japan are indistinguishable from zero.) And it let cities specialize in marketing this initiative.

And specialize they did.

A number of cities in Japan, including my adoptive home town of Ogaki, have made this offer: for a no-cost-to-you donation of $100 or more, the city will send someone out to any grave in the city limits. That person will clean the grave, make an appropriate offering, and send you a photo. This is a beautiful thing.

Most of the gifts are more prosaic. Locally produced food is very popular. If you miss the taste of home, they’ve got you covered.

Cities partnered with local firms to handle the e-commerce aspect, and eventually with platforms to bundle many different items into a single donation; think of it as a shopping cart you could fill with donated money.

And then someone asked a fateful question.

Where is your hometown, anyway?

The Furusato Nouzei system does not define what a “hometown” is. This is mostly by design; Japan historically has a very long-lasting official record of birthplaces which follows one throughout life called the Family Register, and (for reasons outside the scope of this post) it is a major societal issue. Additionally, there was some sentiment that one could have a it-feels-like-home connection to a city that wasn’t necessarily one’s birthplace.

Maybe you were born in Tokyo but lived 30 years in a small town in Aichi, like my wife. Maybe you were born abroad but lived 10 years in Ogaki, like me. Maybe you just loved the onsen in Gero and wanted to subsidize them. The government wasn’t willing to adjudicate one’s “true” hometown; 帰る場所 is where the heart is.

And then some bureaucrat realized that this created a market: you, as a city government, can bid for taxpayers to select you as a hometown.

How does that work?

Well, remember the sites which are acting as brokers for donations? They all have search engines, so that you can search by e.g. who has wagyu available if that is your thing.

Your thing could, plausibly, be travel to your hometown. So your hometown could, plausibly, buy you tickets back to home. But this would be gratuitously operationally intensive.

You have you call city hall. They have to arrange transport. Why do this when Japan is a country with perfectly functioning travel agencies? It would be far better for everyone for your hometown to just send you a gift card to a travel agency.

See where this is going yet? A gift card for e.g. Japan’s largest travel agency is a highly liquid cash equivalent. In addition to using it for any good or service from that travel agency, you could liquidate it for about 97 cents on the dollar in any gift certificate exchange in the country. (These are extraordinarily common in Japan.)

A few rounds of vigorous capitalism later, many rural towns without large expatriate (inpatriate?) populations and without much to differentiate them in terms of local food had bid the consideration for a donation up, up, up. Eventually the central government stepped in and said that the maximum they’d allow is you rewarding a taxpayer with 50% of the donation in consideration.

So, if you “donate” ~3% of your gross salary to one of these cities (which is 1:1 matched by e.g. Tokyo; you’re donating someone else’s money), they will give you ~1.5% of it back in all-but-cash.

In 2008, about 33,000 people participated in the Furusato Nouzei system, principally out of genuine charitable concern. In 2016, it was about 2.2 million. They donated on the order of $2.5 billion. The primary accelerant was the bidding war. A contributor was the popularization of Internet sites to broker the donations, which substantially reduce the friction required to participate.

Running a site is a very good business to be in; it’s like running an e-commerce business with the special wrinkle that your customers are entirely price insensitive. There are a variety of smaller concerns, but the large Japanese Internet giants (Rakuten, Yahoo, etc) all use their massive built-in distribution and relationships to get an edge here. (The business model is simple: take the money from taxpayers, deduct a cut, spend some on gifts authorized by the city, and remit the remainder to the city periodically. You then periodically give the city an Excel file full of taxpayers. The city periodically sends their donors the requisite paperwork to get the tax credit the next year.)

I’d estimate that intermediaries probably soak up somewhere between 5% and 10% of the total donated. This is quite inefficient to accomplish a government-to-government reallocation of resources, but by the standards of Japanese public works projects it is practically free.

(Jokes aside: my estimate is informed by the fact that the margins are rich enough such that the intermediaries will happily support you making a donation on credit cards. The actual numbers are probably in a public disclosure somewhere but I don’t have enough time to go looking.)

Is this sustainable?

Probably? There has been some talk of rolling back the bidding war via administrative fiat, but the cities are quite opposed to this. It’s a great game theory problem: unless a supermajority of cities collectively agrees to limit gifts to a token number, it’s strongly in a city’s interest to duck the central government’s questionnaires and not express any objection to the status quo. (Also remember that the natural anchor for reciprocation is set quite high across much of Japan; the government might succeed in capping reciprocation at 30% but that might be a hard floor for the ceiling.)

The penetration rate of this system will likely continue quickly increasing. It’s socially viral: a tax optimization that virtually anyone can take advantage of, has the explicit backing of the government, and feels wholesome. If you’re one of the relatively few taxpayers in Japan who has an accountant, expect them to tell you about this in detail and strongly recommend you max our your contribution every year.

Widespread gaming or no, the system pretty much works according to the internal aims. Cities get a list of their internal diaspora, and do make considerably more effort to stay in touch with them than they did previously. (This includes lovely holiday cards and sometimes even I-can’t-believe-they’re-not-alumni-magazines.) You really do get plums from childhood in your mail from your hometown (if you don’t optimize for cash equivalents). Cities with declining local tax bases really do get enough money to do material projects with. Tokyo takes a hit to revenue but can afford it.

And there, that’s Japan’s most novel redistribution program in a nutshell.

If you live in Japan and want to take advantage of this, hit up your local Google; many sites are happy to make it happen for you. (I don’t endorse any in particular, but any of the top brands or organic search results will work substantially as advertised.)

[0]: I had been of the impression up until today that it was literally not on the English-speaking Internet, but this seems to have changed in the last few years. That said, nobody seems to have written about the policy angle in English yet, so here we are.