Does prospect theory explain ethical decision making? Evidence from tax compliance

Abstract

Prospect theory is often used to predict individuals’ risky tax decisions. For example, individuals who are in a tax due (refund) position are predicted to engage in more (less) tax noncompliance. This is known as the “withholding phenomenon”. However, tax noncompliance is not just risky, it is also unethical. We hypothesize that because there is an ethical component inherent in this risky decision, the feelings described by prospect theory are insufficient to cause increased risk-seeking. In a series of experiments, we show that moral disengagement is the primary theoretical mechanism that explains noncompliant tax behavior. The feelings evoked from being in a loss domain provide motivation for individuals to morally disengage, while moral disengagement is directly related to noncompliant tax behavior. We also develop an intervention that deters individuals from morally disengaging, specifically when they are in a tax due position. These results have important practical and theoretical implications.