More and cheaper haircuts after VAT cut? On the efficiency and incidence of service sector consumption taxes ¬リニ

a r t i c l e i n f o Consumption tax rates targeted at specific sectors are often reformed without any empirical knowledge about the efficiency of these policies. This paper sheds light on tax incidence as well as the efficiency issue, the potential for welfare improving reform, by studying the impact of value added taxes (VAT) on prices and quantities of labor intensive services. I utilize a VAT reform targeted at a specific service sector, which creates a natural experiment set up. The VAT for hairdressing services in Finland was reduced from 22% to 8%, and the previous tax treatment still applied to other labor intensive services. The choice of the treatment and control groups was exogenous to circumstances in Finland, since these groups were selected from a wider European setting. The results suggest that hairdressers cut their prices only by half of what a complete pass-through would have implied, and that there was hardly any adjustment in equilibrium quantity due to the reform. Hairdressers were able to increase their profits significantly. There is important heterogeneity in the results according to firm size. Economic literature provides sound theoretical insights for efficient consumption taxation (Crawford et al., 2010). Tax incidence depends on the relative elasticities of supply and demand, and the deadweight loss from taxation depends on the effect of taxes on equilibrium quantity. In more elaborate optimal consumption taxation models the focus is usually on the behavior of consumers, i.e. on demand elasticity. Here, demand elasticity affects the extent that a given tax rate distorts the economy (Ramsey, 1927 and Diamond and Mirrlees, 1971), or extent that the labor supply of consumers is distorted via the correlation between consumption and labor supply (Atkinson and Stiglitz, 1976). Also, the small share of leisure time used to consume services could make them a good target for reduced VAT rates, but this result also depends inversely on the demand elasticities (Kleven et al., 2000 and Kleven, 2004). Despite the vast theoretical literature on this subject, the empirical work is not as widely developed. The tax incidence question has been analyzed in a number of papers, but there remain some gaps (see Adam et al., 2011, Section 8.3). Even larger gaps exist in our current understanding on the question of efficiency. Even though estimating demand systems gives valuable structural insights on this (Deaton and Muellbauer, 1980 and Banks et al., 1997), …