Tax evasion analysis is typically based on an expected utility theory (EUT) framework. However, this leads to several qualitative and quantitative puzzles. Given actual probabilities of audit and penalty rates the return on evasion ranges from 91-98 percent. So why don’t most of us evade? Furthermore, an EUT based analysis predicts that we should evade less as the tax rate increases (Yitzhaki puzzle). Intuition and the bulk of the evidence do not support this result. This paper analyzes tax evasion using, instead, Kahneman and Tversky’s cumulative prospect theory. Under prospect theory we show that (1) the calibration results predict empirically plausible magnitudes of tax evasion despite low audit probabilities and penalty rates, and (2) the Yitzhaki puzzle is easily explained. Thus, our paper argues that not only does prospect theory provide a satisfactory explanation of tax evasion, it also argues that the phenomenon of tax evasion provides independent confirmation of prospect theory.
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Paper provided by Department of Economics, University of Leicester in its series Discussion Papers in Economics with number
05/23.
Length: Date of creation: Nov 2005 Date of revision:
Aug 2006 Handle: RePEc:lec:leecon:05/23
Contact details of provider: Postal: Department of Economics University of Leicester, University Road. Leicester. LE1 7RH. UK Phone: +44 (0)116 252 2887 Fax: +44 (0)116 252 2908 Email: Web page: http://www.le.ac.uk/economics/
Find related papers by JEL classification: D81 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Criteria for Decision-Making under Risk and Uncertainty H26 - Public Economics - - Taxation, Subsidies, and Revenue - - - Tax Evasion K42 - Law and Economics - - Legal Procedure, the Legal System, and Illegal Behavior - - - Illegal Behavior and the Enforcement of Law
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