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Why do people pay taxes? Prospect theory versus expected utility theory

[journal article]

Dhami, Sanjit; al-Nowaihi, Ali

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Please use the following Persistent Identifier (PID) to cite this document:http://nbn-resolving.de/urn:nbn:de:0168-ssoar-199556

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Abstract Using actual probabilities of audit and penalty rates, the return on evasion is 91–98%. So why do not most of us evade? Existing analysis, based on expected utility theory (EUT) is unable to explain this. Furthermore, and contrary to intuition and the bulk of evidence, EUT predicts that evasion should be decreasing in the tax rate (Yitzhaki puzzle). We apply Tversky and Kahneman’s [Tversky, A., Kahneman, D., 1992. Advances in prospect theory: cumulative representation of uncertainty. Journal of Risk and Uncertainty 5, 297–323] cumulative prospect theory to tax evasion. We show that prospect theory provides a much more satisfactory account of tax evasion including an explanation of the Yitzhaki puzzle. This also provides independent confirmation of prospect theory.
Classification Public Finance
Free Keywords Reference dependence; Loss aversion; Decision weights; Prospect theory; Expected utility theory; Tax evasion; Optimal taxation
Document language English
Publication Year 2007
Page/Pages p. 171-192
Journal Journal of Economic Behavior & Organization, 64 (2007) 1
DOI http://dx.doi.org/10.1016/j.jebo.2006.08.006
Status Postprint; peer reviewed
Licence PEER Licence Agreement (applicable only to documents from PEER project)