Optimal income taxation in the presence of tax evasion: Expected utility versus prospect theory
AbstractThe predictions of expected utility theory (EUT) applied to tax evasion are flawed on two counts: (i) They are quantitatively in error by huge orders of magnitude. (ii) Higher taxation is predicted to lower evasion, which is at variance with the evidence. An emerging literature in behavioral economics, most notably based on prospect theory (PT), has shown that behavioral economics is much better at explaining tax evasion. We extend this literature to incorporate issues of optimal taxation. As a benchmark for a successful theory, we require that it should explain, jointly, the facts on the tax rate, tax gap and the level of government expenditure. We find that when taxpayers use EUT (respectively, PT) and the optimal tax is derived from a social welfare function that also uses EUT (respectively, PT), then, the calibration results are completely at odds with the facts. However, when taxpayers use PT but the social welfare function uses standard EUT, there is a very close match between the predictions and the facts. This has important implications for context dependent preferences but also for the newly emerging literature on liberalism versus paternalism in behavioral economics.
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Bibliographic InfoPaper provided by Department of Economics, University of Leicester in its series Discussion Papers in Economics with number 07/10.
Date of creation: Sep 2007
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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
This paper has been announced in the following NEP Reports:
- NEP-ALL-2007-10-06 (All new papers)
- NEP-LAW-2007-10-06 (Law & Economics)
- NEP-PBE-2007-10-06 (Public Economics)
- NEP-PUB-2007-10-06 (Public Finance)
- NEP-UPT-2007-10-06 (Utility Models & Prospect Theory)
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