Optimal Income Taxation in the Presence of Tax Evasion: Expected Utility Versus Prospect Theory

Sanjit Dhami,Ali Al-Nowaihi

doi:10.2139/ssrn.1130794

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.

Highlights

Issues of tax evasion are extremely important for all countries
expected utility theory (EUT) makes the prediction that under reasonable attitudes to risk, namely, non-increasing absolute risk aversion, the taxpayer evades less as the tax rate goes up
We extend the analysis of Dhami and al-Nowaihi (2007) by asking what should the optimal income tax be, when taxpayers use prospect theory (PT) to make their tax evasion decision? This is a substantially more di¢ cult question because the appropriate welfare criteria under behavioral economics is, as yet, an unsettled area

Summary

Introduction

Issues of tax evasion are extremely important for all countries. Losses to society from tax evasion are huge. Dhami and al-Nowaihi (2007) apply Kahneman and Tversky’s (1979) prospect theory[3] (PT) to the tax evasion decision facing a taxpayer. They show that while EUT gives the correct qualitative results for the e¤ects of the probability of detection and the penalty rate, there are several problems. The implication is that tax evasion will be at a minimum when the tax rate is 100 percent This result, due to Yitzhaki (1974), is contradicted by the bulk of empirical evidence. At existing penalty rates and detection probabilities, the quantitative predictions of EUT on the extent of tax evasion are wrong by a factor of about 100. PT gives the correct quantitative and qualitative results.[4]

Results

Discussion

Conclusion