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Why Do People Pay Taxes? An Explanation Based On Loss Aversion And Overweighting of Low Probabilities

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  • Sanjit Dhami
  • Ali al-Nowaihi

    ()

Abstract

Given actual probabilities of audit and penalty rates observed in the real world, tax evasion should be an extremely attractive gamble to an expected utility maximizer. However, in practice, one observes too much compliance relative to the predictions of expected utility. This paper considers an alternative theoretical model that is based on Kahneman and Tversky's cumulative prospect theory. The model predicts empirically plausible magnitudes of tax evasion despite low audit probabilities and penalty rates. An increase in the tax rate leads to an increase in the amount evaded- a result, which is both, intuitive, and factual, but is contrary to the prediction made by expected utility theory. Furthermore, the optimal tax rates predicted by prospect theory, in the presence of tax evasion behaviour, are consistent with actual tax rates.

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Bibliographic Info

Paper provided by Department of Economics, University of Leicester in its series Discussion Papers in Economics with number 03/18.

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Date of creation: Dec 2003
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Handle: RePEc:lec:leecon:03/18

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Related research

Keywords: Tax Evasion; Loss Aversion; Decision Weights; Prospect Theory; Optimal taxation;

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Cited by:
  1. Wolfram F. Richter, 2007. "Geplante Steuerhinterziehung und ihre effiziente Bestrafung," RWI Materialien, Rheinisch-Westfälisches Institut für Wirtschaftsforschung, pages 31, 08.

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