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Moral Hazard, Income Taxation and Prospect Theory

  • Ravi Kanbur
  • Jukka Pirttilä
  • Matti Tuomala

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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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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  1. Tuomala, Matti, 1990. "Optimal Income Tax and Redistribution," OUP Catalogue, Oxford University Press, number 9780198286059, March.
  2. Oswald, Andrew J., 1983. "Altruism, jealousy and the theory of optimal non-linear taxation," Journal of Public Economics, Elsevier, vol. 20(1), pages 77-87, February.
  3. Jewitt, Ian, 1988. "Justifying the First-Order Approach to Principal-Agent Problems," Econometrica, Econometric Society, vol. 56(5), pages 1177-90, September.
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