VAT reduction and tax incidence: Evidence from a Finnish VAT reform on restaurant services

Abstract

Relative to the comprehensive theoretical literature on tax incidence, the empirical research on the subject is still sparse. The purpose of this thesis is to complement the research on tax incidence by studying a tax reform on restaurant services in Finland in 2010. The case study concentrates on defining the consumer price effects of a value-added tax (VAT) reduction of nine percentage points. In addition to the case study, an overview of the existing theoretical and empirical literature on positive and normative aspects of commodity taxation is provided.

The study utilizes the difference-in-differences method with fixed effects specification to reveal the causal effect of tax reduction on consumer price. An EU level directive change facilitated a tax change exogenous to the economic conditions in the Finnish restaurant industry. The counterfactual price development is controlled by the price development in Estonian restaurants. The DID OLS with fixed effects is used to derive an average of the consumer price reduction based on the number of restaurants. The Weighted Least Squares method is applied to provide a sales-based average of the change in the consumer price and thus to reflect the change in the restaurant expenses of an average consumer.

The study found undershifting of tax change to consumer prices. The price reduction of 2,3 percent translates into a pass-through rate of 31 percent. The chain restaurants and the restaurants belonging to the labor market organization and lobbyist MaRa demonstrate a higher-than-average reduction in the consumer price, being 4,6 percent and 4,1 percent, respectively. The sales-weighted average of the pass-through rate is higher than the average based on the number of restaurants, revealing the higher tendency of high-sales restaurants to shift tax reduction to their prices. The sales-weighted average of the price effects ranges from 5,3 to 6,5 percent, corresponding to a 71 to 88 percent pass-through rate of tax change, depending on the definition of weights.