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Solving the Yitzhaki Paradox

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  • Gwenola Trotin

    () (Aix-Marseille University (Aix-Marseille School of Economics), CNRS & EHESS)

Abstract

This paper examines the determinants of tax evasion under prospect theory. For prospect theory, reference dependence is a fundamental element (the utility function depends on gains and losses relative to a reference point and not on final wealths as in expected utility theory). In order to identify the determinants of the income tax evasion decision, a general reference income is used. We show that results obtained under expected utility theory are not robust. In particular, tax evasion is increasing in the tax rate as soon as a suitable relative risk aversion measure is larger with auditing, than without. With this simple and testable condition, prospect theory provides a general framework consistent with empirical evidence for the tax evasion behaviour problem.

Suggested Citation

  • Gwenola Trotin, 2012. "Solving the Yitzhaki Paradox," AMSE Working Papers 1238, Aix-Marseille School of Economics, Marseille, France.
  • Handle: RePEc:aim:wpaimx:1238
    as

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    File URL: http://www.amse-aixmarseille.fr/sites/default/files/_dt/2012/wp_2012_-_nr_38.pdf
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    References listed on IDEAS

    as
    1. Kahneman, Daniel & Tversky, Amos, 1979. "Prospect Theory: An Analysis of Decision under Risk," Econometrica, Econometric Society, vol. 47(2), pages 263-291, March.
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    3. Matthew Rabin, 2000. "Risk Aversion and Expected-Utility Theory: A Calibration Theorem," Econometrica, Econometric Society, pages 1281-1292.
    4. Drazen Prelec, 1998. "The Probability Weighting Function," Econometrica, Econometric Society, vol. 66(3), pages 497-528, May.
    5. James Andreoni & Brian Erard & Jonathan Feinstein, 1998. "Tax Compliance," Journal of Economic Literature, American Economic Association, pages 818-860.
    6. Friedland, Nehemiah & Maital, Shlomo & Rutenberg, Aryeh, 1978. "A simulation study of income tax evasion," Journal of Public Economics, Elsevier, pages 107-116.
    7. 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.
    8. 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 Elsevier.
    9. Michele Bernasconi & Alberto Zanardi, 2004. "Tax Evasion, Tax Rates, and Reference Dependence," FinanzArchiv: Public Finance Analysis, Mohr Siebeck, Tübingen, vol. 60(3), pages 422-422, September.
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    11. Dhami, Sanjit & al-Nowaihi, Ali, 2007. "Why do people pay taxes? Prospect theory versus expected utility theory," Journal of Economic Behavior & Organization, Elsevier, pages 171-192.
    12. Yaniv, Gideon, 1999. "Tax Compliance and Advance Tax Payments: A Prospect Theory Analysis," National Tax Journal, National Tax Association, pages 753-764.
    13. Alm, James & McClelland, Gary H. & Schulze, William D., 1992. "Why do people pay taxes?," Journal of Public Economics, Elsevier, pages 21-38.
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    15. Clotfelter, Charles T, 1983. "Tax Evasion and Tax Rates: An Analysis of Individual Returns," The Review of Economics and Statistics, MIT Press, pages 363-373.
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    17. James Andreoni & Brian Erard & Jonathan Feinstein, 1998. "Tax Compliance," Journal of Economic Literature, American Economic Association, pages 818-860.
    18. 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, pages 332-382.
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    More about this item

    Keywords

    Tax evasion; Prospect theory; Reference dependence; Decision weights.;

    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 and Avoidance
    • K42 - Law and Economics - - Legal Procedure, the Legal System, and Illegal Behavior - - - Illegal Behavior and the Enforcement of Law

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