Why Do People Pay Taxes? An Explanation Based On Loss Aversion And Overweighting of Low Probabilities

Sanjit Dhami and Ali al-Nowaihi ()

No 03/18, Discussion Papers in Economics from Division of Economics, School of Business, University of Leicester

Abstract: Given actual probabilities of audit and penalty rates observed in the real world, tax evasion should be an extremely attractive gamble to an expected utility maximizer. However, in practice, one observes too much compliance relative to the predictions of expected utility. This paper considers an alternative theoretical model that is based on Kahneman and Tversky's cumulative prospect theory. The model predicts empirically plausible magnitudes of tax evasion despite low audit probabilities and penalty rates. An increase in the tax rate leads to an increase in the amount evaded- a result, which is both, intuitive, and factual, but is contrary to the prediction made by expected utility theory. Furthermore, the optimal tax rates predicted by prospect theory, in the presence of tax evasion behaviour, are consistent with actual tax rates.

Keywords: Tax Evasion; Loss Aversion; Decision Weights; Prospect Theory; Optimal taxation (search for similar items in EconPapers)
JEL-codes: D81 H21 H26 K42 (search for similar items in EconPapers)
Date: 2003-12
New Economics Papers: this item is included in nep-lab, nep-law, nep-mic, nep-pbe and nep-pub
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Citations: View citations in EconPapers (3)

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