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

Sanjit Dhami and Ali al-Nowaihi ()

No 07/10, Discussion Papers in Economics from Division of Economics, School of Business, University of Leicester

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

Keywords: Prospect theory; Expected utility theory; Tax evasion; Optimal taxation; Normative versus positive economics; Context dependent preferences; Liberalism; Paternalism (search for similar items in EconPapers)
JEL-codes: D81 H26 K42 (search for similar items in EconPapers)
Date: 2007-09
New Economics Papers: this item is included in nep-law, nep-pbe, nep-pub and nep-upt
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Citations: View citations in EconPapers (3)

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