Why Do People Pay Taxes? Prospect Theory Versus Expected Utility Theory

Journal of Economic Behavior and Organization, Vol. 64, 2007

University of Leicester, Department of Economics Working Paper No. 05/23

31 Pages Posted: 8 May 2008

See all articles by Sanjit Dhami

Sanjit Dhami

University of Leicester - Department of Economics

Ali al-Nowaihi

University of Leicester - Department of Economics

Date Written: 08/2006

Abstract

Using actual probabilities of audit and penalty rates, the return on evasion is 91-98%. So why do not most of us evade? Existing analysis, based on expected utility theory (EUT) is unable to explain this. Furthermore, and contrary to intuition and the bulk of evidence, EUT predicts that evasion should be decreasing in the tax rate (Yitzhaki puzzle).We apply Tversky and Kahneman's [Tversky, A., Kahneman, D., 1992. Advances in prospect theory: cumulative representation of uncertainty. Journal of Risk and Uncertainty 5, 297-323] cumulative prospect theory to tax evasion. We show that prospect theory provides a much more satisfactory account of tax evasion including an explanation of the Yitzhaki puzzle. This also provides independent confirmation of prospect theory.

Keywords: Reference dependence, Loss aversion, Decision weights, Prospect theory, Expected utility theory, Tax evasion, Optimal taxation

JEL Classification: D81, H26, K42

Suggested Citation

Dhami, Sanjit and al-Nowaihi, Ali, Why Do People Pay Taxes? Prospect Theory Versus Expected Utility Theory (08/2006). Journal of Economic Behavior and Organization, Vol. 64, 2007, University of Leicester, Department of Economics Working Paper No. 05/23, Available at SSRN: https://ssrn.com/abstract=1130783

Sanjit Dhami (Contact Author)

University of Leicester - Department of Economics ( email )

Ali Al-Nowaihi

University of Leicester - Department of Economics ( email )

Department of Economics
Leicester LE1 7RH, Leicestershire LE1 7RH
United Kingdom

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