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More haircut after VAT cut? On the efficiency of service sector consumption taxes

  • Tuomas Kosonen

Consumption tax rates targeted at specific sectors are often reformed without empirical knowledge about the efficiency of these policies. This paper sheds light on the efficiency issue, the potential for welfare improving reform, by studying the incidence of value added taxes (VAT) on prices and quantities of barber services traded. I also study the incidence on the profits made by the targeted firms. I utilize a VAT reform targeted at a specific service sector which creates a natural experiment set up. VAT for hairdressing services in Finland was reduced from 22% to 8%, whereas the normal tax treatment still applied to beauty salons and other labor intensive services. The choice of the treatment and control groups was exogenous to circumstances in Finland, since these groups were selected in a more wider European setting. The results suggest that hairdressers cut their prices only by half of what complete pass-through would have implied, and that there was hardly any adjustment in the equilibrium quantity due to the reform. Instead of lowering prices, most hairdressers were able to increase their profits. There is important heterogeneity in the results according to firm size.

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Paper provided by Government Institute for Economic Research Finland (VATT) in its series Working Papers with number 49.

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Date of creation: 26 Sep 2013
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Handle: RePEc:fer:wpaper:49
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  1. Poterba, James M., 1996. "Retail Price Reactions to Changes in State and Local Sales Taxes," National Tax Journal, National Tax Association, vol. 49(2), pages 165-76, June.
  2. Hamilton, Stephen F., 1999. "Tax incidence under oligopoly: a comparison of policy approaches," Journal of Public Economics, Elsevier, vol. 71(2), pages 233-245, February.
  3. Marion, Justin & Muehlegger, Erich, 2011. "Fuel tax incidence and supply conditions," Journal of Public Economics, Elsevier, vol. 95(9), pages 1202-1212.
  4. Myles, Gareth D., 1989. "Ramsey tax rules for economies with imperfect competition," Journal of Public Economics, Elsevier, vol. 38(1), pages 95-115, February.
  5. James Alm & Edward Sennoga & Mark Skidmore, 2009. "Perfect Competition, Urbanization, And Tax Incidence In The Retail Gasoline Market," Economic Inquiry, Western Economic Association International, vol. 47(1), pages 118-134, 01.
  6. Atkinson, A. B. & Stiglitz, J. E., 1976. "The design of tax structure: Direct versus indirect taxation," Journal of Public Economics, Elsevier, vol. 6(1-2), pages 55-75.
  7. Besley, Timothy J. & Rosen, Harvey S., 1999. "Sales Taxes and Prices: An Empirical Analysis," National Tax Journal, National Tax Association, vol. 52(n. 2), pages 157-78, June.
  8. Carbonnier, Clement, 2007. "Who pays sales taxes? Evidence from French VAT reforms, 1987-1999," Journal of Public Economics, Elsevier, vol. 91(5-6), pages 1219-1229, June.
  9. Emmanuel Saez, 2000. "The Desirability of Commodity Taxation under Non-Linear Income Taxation and Heterogeneous Tastes," NBER Working Papers 8029, National Bureau of Economic Research, Inc.
  10. E. Glen Weyl & Michal Fabinger, 2013. "Pass-Through as an Economic Tool: Principles of Incidence under Imperfect Competition," Journal of Political Economy, University of Chicago Press, vol. 121(3), pages 528 - 583.
  11. Diamond, Peter A & Mirrlees, James A, 1971. "Optimal Taxation and Public Production II: Tax Rules," American Economic Review, American Economic Association, vol. 61(3), pages 261-78, June.
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