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Optimal income taxation in the presence of tax evasion: Expected utility versus prospect theory

By Sanjit Dhami and Ali al-Nowaihi


The predictions of expected utility theory (EUT) applied to tax evasion are\ud awed on two counts: (i) They are quantitatively in error by huge orders of mag-\ud nitude. (ii) Higher taxation is predicted to lower evasion, which is at variance with\ud the evidence. An emerging literature in behavioral economics, most notably based\ud on prospect theory (PT), has shown that behavioral economics is much better at\ud explaining tax evasion. We extend this literature to incorporate issues of optimal\ud taxation. As a benchmark for a successful theory, we require that it should explain,\ud jointly, the facts on the tax rate, tax gap and the level of government expenditure.\ud We nd that when taxpayers use EUT (respectively, PT) and the optimal tax is de-\ud rived from a social welfare function that also uses EUT (respectively, PT), then, the\ud calibration results are completely at odds with the facts. However, when taxpayers\ud use PT but the social welfare function uses standard EUT, there is a very close match\ud between the predictions and the facts. This has important implications for context\ud dependent preferences but also for the newly emerging literature on liberalism versus\ud paternalism in behavioral economics

Topics: Prospect theory, Expected utility theory, Tax evasion, Optimal taxation, Normative versus positive economics, Context dependent preferences, Liberalism, Paternalism
Publisher: Dept. of Economics, University of Leicester
Year: 2007
OAI identifier: oai:lra.le.ac.uk:2381/7467

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