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

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.