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Moral Hazard, Income Taxation and Prospect Theory

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  • Ravi Kanbur
  • Jukka Pirttilä
  • Matti Tuomala

Abstract

The standard theory of optimal income taxation under uncertainty has been developed under the assumption that individuals maximise expected utility. However, prospect theory has now been established as an alternative model of individual behaviour, with empirical support. This paper explores the theory of optimal income taxation under uncertainty when individuals behave according to the tenets of prospect theory. It is seen that many of the standard results are modified in interesting ways. The first-order approach for solving the optimisation problem is not valid over the domain of losses, and the marginal tax schedule offers full insurance around the reference consumption level. The implications of non-welfarist objectives under income uncertainty are also examined. Copyright � The editors of the "Scandinavian Journal of Economics" 2008 .

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Bibliographic Info

Article provided by Wiley Blackwell in its journal Scandinavian Journal of Economics.

Volume (Year): 110 (2008)
Issue (Month): 2 (06)
Pages: 321-337

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Handle: RePEc:bla:scandj:v:110:y:2008:i:2:p:321-337

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Web page: http://onlinelibrary.wiley.com/journal/10.1111/(ISSN)1467-9442

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  1. Jewitt, Ian, 1988. "Justifying the First-Order Approach to Principal-Agent Problems," Econometrica, Econometric Society, vol. 56(5), pages 1177-90, September.
  2. Tuomala, Matti, 1990. "Optimal Income Tax and Redistribution," OUP Catalogue, Oxford University Press, number 9780198286059, September.
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Cited by:
  1. Ravi Kanbur & Jukka Pirttilä & Matti Tuomala, 2006. "Non-Welfarist Optimal Taxation And Behavioural Public Economics," Journal of Economic Surveys, Wiley Blackwell, vol. 20(5), pages 849-868, December.
  2. Gwenola Trotin & Amedeo Piolatto, 2011. "Optimal tax enforcement under prospect theory," Working Papers. Serie AD 2011-24, Instituto Valenciano de Investigaciones Económicas, S.A. (Ivie).
  3. Rablen, Matthew D., 2010. "Performance targets, effort and risk-taking," Journal of Economic Psychology, Elsevier, vol. 31(4), pages 687-697, August.
  4. Marcelo Arbex & Enlinson Mattos, 2010. "Poverty and the Optimal General Income Tax-cum-Audit Policy," Working Papers 02-2010, Universidade de São Paulo, Faculdade de Economia, Administração e Contabilidade de Ribeirão Preto.
  5. Amit Kothiyal & Vitalie Spinu & Peter Wakker, 2011. "Prospect theory for continuous distributions: A preference foundation," Journal of Risk and Uncertainty, Springer, vol. 42(3), pages 195-210, June.
  6. Robin Boadway & Motohiro Sato, 2011. "Optimal Income Taxation with Uncertain Earnings: A Synthesis," CESifo Working Paper Series 3654, CESifo Group Munich.
  7. Xianhua Dai, 2011. "Optimal Taxation under Income Uncertainty," Annals of Economics and Finance, Society for AEF, vol. 12(1), pages 121-138, May.

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