Abstract
This paper discusses the capabilities of a class of microfounded equilibrium models, augmented with Prospect Theory elements in the spirit of al- Nowaihi and Dhami (2007), to address several open questions in the analysis of tax evasion and compliance decisions. There are three main results: i) there exists a unique equilibrium with a tax evasion, consistent with the empirical estimates for the United States economy; ii) the model predicts a positive relationship between tax rate and evasion rate, while offering a solution to the so called Yitzhaki puzzle; iii) the «framing effect» plays a significant role in supporting these results; this is a distinctive characterstic of this class of model, typically not present in simple individual choice models. Furthermore, the model also allows us to investigate some potentially relevant effects of labor supply behavior on the tax compliance decisions.
Highlights
Tax evasion, i.e., the illegal concealment of taxable activity, is a relevant issue in public economics, whose impact extends beyond developing economies, interesting many developed economies, as testified by the most recent estimations of «shadow» or undeclared economy around the world
This paper presents a novel modelling framework in which Prospect Theory (PT) is integrated into an otherwise simple and standard model of market equilibrium with an aggregate-representative agent, in the context of tax compliance choices
The market equilibrium environment allows us to define the choice problem so as to take into account all the relevant features of PT and in particular the framing effect, which proved to be difficult for the existing models based on the individual-choice approach
Summary
I.e., the illegal concealment of taxable activity, is a relevant issue in public economics, whose impact extends beyond developing economies, interesting many developed economies, as testified by the most recent ( still tentative) estimations of «shadow» or undeclared economy around the world (see, e.g., Medina and Schneider 2018). The inclusion of tax evasion in standard models of individual choice (of microeconomic nature) brought about a number of interesting «puzzles», or unexpected or surprising results, that cast doubts on the ability of standard microeconomic theory (of individual choice) to properly explain the phenomenon. We develop a calibration exercise so as to properly fit the United States economy key characteristics, relevant for our issues, with particular attention to the evasion rate Under this calibration, the model predicts that an increase in the tax rate leads to an increase in tax evasion, in line with the empirical evidence, while allowing us to investigate the relevance and the impact of the framing effect in the context of the tax compliance decision.
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