This article was originally published by the European Correspondent
Sitting at the hairdresser in Oulu, Finland, in 2007, your stylist informs you that from next week you’ll be paying €2 less for your haircut. Would that be enough to make you come back more often?
The government hoped so. As part of an EU-wide experiment, the Finnish authorities lowered the Value Added Tax (VAT) on hairdressing services in 2007 to see whether lower prices would bring more people through the door and help the sector create more jobs.
Back at the barber, something doesn’t add up. The VAT on that haircut dropped by €4, so why does the price only go down by €2? Turns out, your hairdresser hasn’t passed on the full benefit of the tax cut. To you, it looks like a discount, but they’ve actually quietly increased prices. Clever.
Five years later, the government returns VAT to its original level. Prices should go back up by €2, plus whatever inflation happened in between. But your hairdresser raises their prices by the full €4.
When there’s a tax cut, you share it – you get a lower price and the hairdresser gets €2 more profit – when there is a tax increase, you pay the full difference. In the end, a temporary tax cut increased prices permanently.
Visualisation by Sebastian Gräff
The figure above, drawn from a study by Benzarti, Carloni, Harju and Kosonen on the VAT experiment, makes this argument quite believable. Beauty salons offer nearly identical services to hairdressers, but were never part of the VAT experiment, meaning any difference in price trends can only be explained by the tax change.
This simple story illustrates what economists call tax incidence: who ultimately bears the burden of a tax.
The answer is largely determined by bargaining power. To respond to business’ burden-sharing, you can ”take your business elsewhere”, but you’ll want to get a haircut eventually. So firms set the price, and you mostly take it. The hairdressers’ experiment shows that the adjustment wasn’t symmetrical. First, prices went down a little, but later shot up a lot.
The same study tested this behaviour across 27 EU countries over 20 years for nearly every category of goods and services. The same asymmetry showed up almost everywhere: VAT reduction resulted in a quiet price increase.
While the cost of a haircut may seem trivial, other examples have had a far greater impact on Europeans’ pockets. In 2022, following Russia’s full-scale invasion of Ukraine, firms raised energy prices by more than what their rising costs justified. According to the International Monetary Fund, this strategy accounted for 45% of eurozone inflation since early 2022 – more than rising import costs, and nearly twice as much as wage growth.
When supply chains are under stress, that behaviour might be explainable. But firms kept raising prices long after energy costs came back down.