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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 .

Suggested Citation

  • Ravi Kanbur & Jukka Pirttilä & Matti Tuomala, 2008. "Moral Hazard, Income Taxation and Prospect Theory," Scandinavian Journal of Economics, Wiley Blackwell, vol. 110(2), pages 321-337, June.
  • Handle: RePEc:bla:scandj:v:110:y:2008:i:2:p:321-337
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    References listed on IDEAS

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    1. Jewitt, Ian, 1988. "Justifying the First-Order Approach to Principal-Agent Problems," Econometrica, Econometric Society, vol. 56(5), pages 1177-1190, September.
    2. Tuomala, Matti, 1990. "Optimal Income Tax and Redistribution," OUP Catalogue, Oxford University Press, number 9780198286059.
    3. Oswald, Andrew J., 1983. "Altruism, jealousy and the theory of optimal non-linear taxation," Journal of Public Economics, Elsevier, pages 77-87.
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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. Garth Heutel, 2017. "Prospect Theory and Energy Efficiency," NBER Working Papers 23692, National Bureau of Economic Research, Inc.
    3. 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.
    4. Amedeo Piolatto & Gwenola Trotin, 2011. "Optimal tax enforcement under prospect theory," Working Papers 2011/29, Institut d'Economia de Barcelona (IEB).
    5. Keisuke Morita, 2015. "Advance Tax Payments And Tax Evasion: A Note," The Singapore Economic Review (SER), World Scientific Publishing Co. Pte. Ltd., vol. 60(05), pages 1-10, December.
    6. Rablen, Matthew D., 2010. "Performance targets, effort and risk-taking," Journal of Economic Psychology, Elsevier, pages 687-697.
    7. Alex Rees-Jones & Dmitry Taubinsky, 2017. "Taxing Humans: Pitfalls of the Mechanism Design Approach and Potential Resolutions," NBER Chapters,in: Tax Policy and the Economy, Volume 32 National Bureau of Economic Research, Inc.
    8. Mehrmann, Annika & Sureth-Sloane, Caren, 2017. "Tax loss offset restrictions and biased perception of risky investments," arqus Discussion Papers in Quantitative Tax Research 222, arqus - Arbeitskreis Quantitative Steuerlehre.
    9. Robin Boadway & Motohiro Sato, 2011. "Optimal Income Taxation with Uncertain Earnings: A Synthesis," CESifo Working Paper Series 3654, CESifo Group Munich.
    10. Hsu, Minchung & Yang, C.C., 2013. "Optimal linear and two-bracket income taxes with idiosyncratic earnings risk," Journal of Public Economics, Elsevier, pages 58-71.
    11. 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.
    12. Xianhua Dai, 2011. "Optimal Taxation under Income Uncertainty," Annals of Economics and Finance, Society for AEF, pages 121-138.

    More about this item

    JEL classification:

    • D81 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Criteria for Decision-Making under Risk and Uncertainty
    • H21 - Public Economics - - Taxation, Subsidies, and Revenue - - - Efficiency; Optimal Taxation

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