Optimal Income Tax Enforcement under Prospect Theory

Abstract

Prospect theory (PT) has become the most accepted alternative to expected utility theory (EUT) as a theory of decision under uncertainty. This paper extends the existing literature on efficient tax and audit schemes, by answering the question as to just how progressive an efficient tax system can be when assuming that taxpayers behave in line with the tenets of PT. Under reasonable assumptions regarding the reference income and the value function of taxpayers, we show that the efficient tax schedule is regressive while audit probabilities are nonincreasing in the declared income. These results are consistent with the previous literature on EUT.

Prospect Theory and Tax Evasion: A Reconsideration of the Yitzhaki Puzzle

“…As pointed out by Dhami and al-Nowaihi (2007) and Prelec (1998), however, empirically the same weighting function is found to apply above and below the reference level, so we assume there to be a single weighting function w . The assumption p ≤ 0 is consistent with the literature on optimal auditing (e.g., Reinganum and Wilde 1986;Piolatto and Trotin 2016).…”

The bomb-crater effect of tax audits: Beyond the misperception of chance

“…In spite of the relatively large debate that followed the AS72 paper, no revolutionary improvement to the theoretical frame has been subsequently added to the AS72 model until recently. Among few exceptions we signal Bernasconi and Zanardi (2004), Dhami and Al-Nowaihi (2007), Piolatto and Rablen (2013), and Piolatto and Trotin (2016). All these papers adopt a Prospect Theory (PT) approach (Kahneman and Tversky, 1979).…”

Consumption adaptation, anticipation‐bias, and optimal income taxation

“…Their paper will thus be the starting point for our analysis of tax policy implications of anticipation‐bias from the point of view of a paternalist government. Our study contributes to the literature that reconsiders optimal income taxation by taking account of recent important behavioral approaches to public economics (see, e.g., Aronsson & Johansson‐Stenman, ; Kanbur & Tuomala, ; Piolatto & Trotin, ). In particular, it complements and extends the recent paper by Tuomala and Tenhunen (), which also addresses the implications of habit formation for optimal taxation in a dynamic economy.…”