Does Hometown Tax Donation System as Interjurisdictional Competition Affect Local Government Efficiency? Evidence from Japanese Municipality level Data

This study analyzes the impact of Hometown Tax Donation (HTD), a unique local fiscal system in Japan, on local government efficiency. It allows residents to make donations to local governments of their choice, receiving deductions on payment of local and national taxes, equivalent to the amount donated, except for small self-paid amounts (JPY2,000, US$15). Moreover, donors can receive gifts from the recipient government in return, depending on the amount donated. Therefore, tax revenue will outflow from the donor residents’ municipalities to other regions, whereas it will inflow to recipient municipalities from other regions. This makes local governments compete to receive donations under the HTD system by trying to enhance their efficiency. On the other hand, HTD may cause misperception of tax prices, thereby leading to inefficient provision of local public services. This study uses stochastic frontier analysis to quantitatively analyze the impact of HTD on the inefficiency of local governments. The findings reveal that municipalities whose revenues are more dependent on HTD tend to be more inefficient. Moreover, greater dependence on intergovernmental grants and local corporate taxation results in inefficiency, thus, providing implications for local public finance on the importance of decentralization. The results also highlight that competition for income through HTD is a zero-sum game, therefore, more fiscal autonomy is needed to ensure healthy competition, thereby, providing new evidence on the relationship between interjurisdictional competition and local government efficiency.