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Why Do People Pay Taxes? Prospect Theory Versus Expected Utility Theory

Sanjit Dhami () and Ali al-Nowaihi ()

No 05/23, Discussion Papers in Economics from Division of Economics, School of Business, University of Leicester

Abstract: Tax evasion analysis is typically based on an expected utility theory (EUT) framework. However, this leads to several qualitative and quantitative puzzles. Given actual probabilities of audit and penalty rates the return on evasion ranges from 91-98 percent. So why don’t most of us evade? Furthermore, an EUT based analysis predicts that we should evade less as the tax rate increases (Yitzhaki puzzle). Intuition and the bulk of the evidence do not support this result. This paper analyzes tax evasion using, instead, Kahneman and Tversky’s cumulative prospect theory. Under prospect theory we show that (1) the calibration results predict empirically plausible magnitudes of tax evasion despite low audit probabilities and penalty rates, and (2) the Yitzhaki puzzle is easily explained. Thus, our paper argues that not only does prospect theory provide a satisfactory explanation of tax evasion, it also argues that the phenomenon of tax evasion provides independent confirmation of prospect theory.

Keywords: Reference Dependence; Loss Aversion; Decision Weights; Prospect Theory; Expected Utility Theory; Tax Evasion; Optimal taxation (search for similar items in EconPapers)
JEL-codes: D81 H26 K42 (search for similar items in EconPapers)
Date: 2005-11, Revised 2006-08
New Economics Papers: this item is included in nep-acc, nep-exp, nep-law, nep-pbe and nep-pub
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