Why do people pay taxes? Prospect theory versus expected utility theory
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.
(This abstract was borrowed from another version of this item.)
If you experience problems downloading a file, check if you have the proper application to view it first. In case of further problems read the IDEAS help page. Note that these files are not on the IDEAS site. Please be patient as the files may be large.
As the access to this document is restricted, you may want to look for a different version under "Related research" (further below) or search for a different version of it.
References listed on IDEAS
Please report citation or reference errors to , or , if you are the registered author of the cited work, log in to your RePEc Author Service profile, click on "citations" and make appropriate adjustments.:
- Stephen Pudney & Monica Hernandez & Ruth Hancock, 2002.
"The Welfare Cost of Means-Testing: Pensioner Participation in Income Support,"
Discussion Papers in Economics
03/2, Department of Economics, University of Leicester.
- Stephen Pudney & Monica Hernandez & Ruth Hancock, 2007. "The welfare cost of means-testing: pensioner participation in income support," Journal of Applied Econometrics, John Wiley & Sons, Ltd., vol. 22(3), pages 581-598.
- Pudney, Stephen & Monica Hernandez & Ruth Hancock, 2003. "The Welfare Cost of Means-Testing: Pensioner Participation in Income Support," Royal Economic Society Annual Conference 2003 171, Royal Economic Society.
- Hernandez, Monica & Pudney, Stephen & Hancock, Ruth, 2006. "The welfare cost of means-testing: pensioner participation in income support," ISER Working Paper Series 2006-12, Institute for Social and Economic Research.
- Friedland, Nehemiah & Maital, Shlomo & Rutenberg, Aryeh, 1978. "A simulation study of income tax evasion," Journal of Public Economics, Elsevier, vol. 10(1), pages 107-116, August.
- Erling Eide, 2001. "Rank dependent expected utility models of tax evasion," ICER Working Papers 27-2001, ICER - International Centre for Economic Research.
- Gordon, James P. P., 1989. "Individual morality and reputation costs as deterrents to tax evasion," European Economic Review, Elsevier, vol. 33(4), pages 797-805, April.
- Michele Bernasconi & Alberto Zanardi, 2004. "Tax Evasion, Tax Rates, and Reference Dependence," FinanzArchiv: Public Finance Analysis, Mohr Siebeck, Tübingen, vol. 60(3), pages 422-, September.
- Ali al-Nowaihi & Sanjit Dhami, 2010. "Probability Weighting Functions," Discussion Papers in Economics 10/10, Department of Economics, University of Leicester.
- N. Gregory Mankiw & Stephen P. Zeldes, 1990.
"The Consumption of Stockholders and Non-Stockholders,"
NBER Working Papers
3402, National Bureau of Economic Research, Inc.
- Mankiw, N. Gregory & Zeldes, Stephen P., 1991. "The consumption of stockholders and nonstockholders," Journal of Financial Economics, Elsevier, vol. 29(1), pages 97-112, March.
- Mankiw, N.G. & Zeldes, S.P., 1990. "The Consumption Of Stockholders And Non-Stockholders," Weiss Center Working Papers 23-90, Wharton School - Weiss Center for International Financial Research.
- Uzi Segal & Avia Spivak, 1988.
"First Order Versus Second Order Risk Aversion,"
UCLA Economics Working Papers
540, UCLA Department of Economics.
- Slemrod, Joel & Yitzhaki, Shlomo, 2002.
"Tax avoidance, evasion, and administration,"
Handbook of Public Economics,
in: A. J. Auerbach & M. Feldstein (ed.), Handbook of Public Economics, edition 1, volume 3, chapter 22, pages 1423-1470
- Alm, James & McClelland, Gary H. & Schulze, William D., 1992. "Why do people pay taxes?," Journal of Public Economics, Elsevier, vol. 48(1), pages 21-38, June.
- Elffers, Henk & Hessing, Dick J., 1997. "Influencing the prospects of tax evasion," Journal of Economic Psychology, Elsevier, vol. 18(2-3), pages 289-304, April.
- Amos Tversky & Daniel Kahneman, 1979.
"Prospect Theory: An Analysis of Decision under Risk,"
Levine's Working Paper Archive
7656, David K. Levine.
- Kahneman, Daniel & Tversky, Amos, 1979. "Prospect Theory: An Analysis of Decision under Risk," Econometrica, Econometric Society, vol. 47(2), pages 263-91, March.
- Clotfelter, Charles T, 1983. "Tax Evasion and Tax Rates: An Analysis of Individual Returns," The Review of Economics and Statistics, MIT Press, vol. 65(3), pages 363-73, August.
- Chris Starmer, 2000. "Developments in Non-expected Utility Theory: The Hunt for a Descriptive Theory of Choice under Risk," Journal of Economic Literature, American Economic Association, vol. 38(2), pages 332-382, June.
- Bernasconi, Michele, 1998. "Tax evasion and orders of risk aversion," Journal of Public Economics, Elsevier, vol. 67(1), pages 123-134, January.
- Shlomo Benartzi & Richard H. Thaler, 1995. "Myopic Loss Aversion and the Equity Premium Puzzle," The Quarterly Journal of Economics, Oxford University Press, vol. 110(1), pages 73-92.
- Tversky, Amos & Kahneman, Daniel, 1992. "Advances in Prospect Theory: Cumulative Representation of Uncertainty," Journal of Risk and Uncertainty, Springer, vol. 5(4), pages 297-323, October.
- Besley, Timothy & Coate, Stephen, 1992.
"Understanding welfare stigma: Taxpayer resentment and statistical discrimination,"
Journal of Public Economics,
Elsevier, vol. 48(2), pages 165-183, July.
- Besley, T. & Coate, S., 1990. "Understanding Welfare Stigma: Taxpayer Resentment And Statistical Discrimination," Papers 42, Princeton, Woodrow Wilson School - Discussion Paper.
- Drazen Prelec, 1998. "The Probability Weighting Function," Econometrica, Econometric Society, vol. 66(3), pages 497-528, May.
- James Andreoni & Brian Erard & Jonathan Feinstein, 1998.
Journal of Economic Literature,
American Economic Association, vol. 36(2), pages 818-860, June.
- Yaniv, Gideon, 1999. "Tax Compliance and Advance Tax Payments: A Prospect Theory Analysis," National Tax Journal, National Tax Association, vol. 52(n. 4), pages 753-64, December.
- Camerer, Colin F & Ho, Teck-Hua, 1994. "Violations of the Betweenness Axiom and Nonlinearity in Probability," Journal of Risk and Uncertainty, Springer, vol. 8(2), pages 167-96, March.
- Baldry, Jonathan C, 1987. "Income Tax Evasion and the Tax Schedule: Some Experimental Results," Public Finance = Finances publiques, , vol. 42(3), pages 357-83.
- Allingham, Michael G. & Sandmo, Agnar, 1972. "Income tax evasion: a theoretical analysis," Journal of Public Economics, Elsevier, vol. 1(3-4), pages 323-338, November.
When requesting a correction, please mention this item's handle: RePEc:eee:jeborg:v:64:y:2007:i:1:p:171-192. See general information about how to correct material in RePEc.
For technical questions regarding this item, or to correct its authors, title, abstract, bibliographic or download information, contact: (Shamier, Wendy)
If you have authored this item and are not yet registered with RePEc, we encourage you to do it here. This allows to link your profile to this item. It also allows you to accept potential citations to this item that we are uncertain about.
If references are entirely missing, you can add them using this form.
If the full references list an item that is present in RePEc, but the system did not link to it, you can help with this form.
If you know of missing items citing this one, you can help us creating those links by adding the relevant references in the same way as above, for each refering item. If you are a registered author of this item, you may also want to check the "citations" tab in your profile, as there may be some citations waiting for confirmation.
Please note that corrections may take a couple of weeks to filter through the various RePEc services.