Abstract
The evidence shows source-dependent entitlement to income sources and individuals are reluctant to part with income they feel more entitled to, e.g., earned labor income. Taxpayers may also be more reluctant to part with tax payments (evade more) from income sources they feel more entitled to- a form of mental accounting. We embed two main hypotheses within a rigorous theoretical model based on prospect theory. From incomes sources they feel more entitled to, taxpayers experience (i) greater loss aversion from paying taxes, and (ii) lower moral costs of evasion. We confirm the predictions of our model through MTurk experiments. Evasion is increasing in the tax rate and decreasing in the audit penalty. Moral costs influence taxpayers’ decisions. Loss aversion, measured “directly” for the first time for each individual in an evasion experiment, reduces evasion, as predicted by our theory. Loss aversion, risk aversion, and their interaction, are critical determinants of evasion.
Highlights
Mental accounting is one of the most promising areas in behavioral economics with a potentially rich domain of applications
We show that a joint consideration of loss aversion and risk aversion, which is a novel feature of our design, is essential to understanding tax evasion behavior
We provide a theoretical analysis of the link between loss aversion and mental accounting, we propose a measure of loss aversion, followed by the “direct” elicitation of loss aversion for each subject using the bisection method
Summary
Mental accounting is one of the most promising areas in behavioral economics with a potentially rich domain of applications. Evidence suggests that (i) individual behavior is dependent on the source of income, and (ii) incomes and expenditures are not fungible across different mental accounts (Kahneman and Tversky, 1984; Thaler, 1985, 1999; Dhami, 2020, Vol 5, Ch. 2). 186) gave a general definition of mental accounting: “I wish to use the term ‘mental accounting’ to describe the entire process of coding, categorizing, and evaluating events.”. The implications of mental accounting are insufficiently explored, in public economics.[1]. Source dependent tax evasion behavior indicates mental accounting because potential tax evaders appear to code and categorize the two different kinds of incomes differently, they are identical in all other respects, including their tax treatment We pose two direct questions. (1) Do people evade different amounts of tax when the source of their taxable income differs but for all other purposes, e.g., in their tax treatment, they are identical?2 We compare labor income, earned in an experimental task, relative to non-labor income which is unearned during the experiment, e.g., bequest, gifts, lottery win, unexpected capital gains. (2) If, ceteris-paribus, evasion depends on the source of income, what is the explanation? Source dependent tax evasion behavior indicates mental accounting because potential tax evaders appear to code and categorize the two different kinds of incomes differently, they are identical in all other respects, including their tax treatment
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