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

University of Leicester, Department of Economics Working Paper No. 07/10

43 Pages Posted: 12 May 2008

See all articles by Sanjit Dhami

Sanjit Dhami

University of Leicester

Ali al-Nowaihi

University of Leicester - Department of Economics

Date Written: September 2007

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.

Keywords: Prospect theory, Expected utility theory, Tax evasion, Optimal taxation, Normative versus positive economics, Context dependent preferences, liberalism versus paternalism

JEL Classification: D81, H26, K42

Suggested Citation

Dhami, Sanjit and al-Nowaihi, Ali, Optimal Income Taxation in the Presence of Tax Evasion: Expected Utility Versus Prospect Theory (September 2007). University of Leicester, Department of Economics Working Paper No. 07/10, Available at SSRN: https://ssrn.com/abstract=1130794 or http://dx.doi.org/10.2139/ssrn.1130794

Sanjit Dhami (Contact Author)

University of Leicester ( email )

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

HOME PAGE: http://www2.le.ac.uk/departments/economics/people/sdhami

Ali Al-Nowaihi

University of Leicester - Department of Economics ( email )

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

Do you have a job opening that you would like to promote on SSRN?

Paper statistics

Downloads
148
Abstract Views
1,173
rank
270,055
PlumX Metrics