Moral Hazard, Income Taxation and Prospect Theory

17 Pages Posted: 22 Jul 2008

See all articles by Ravi Kanbur

Ravi Kanbur

Cornell University; Centre for Economic Policy Research (CEPR); IZA Institute of Labor Economics

Jukka Pirttila

United Nations - World Institute for Development Economics Research (UNU/WIDER); Tampere University of Technology

Matti Tuomala

University of Tampere

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Abstract

The standard theory of optimal income taxation under uncertainty has been developed under the assumption that individuals maximise expected utility. However, prospect theory has now been established as an alternative model of individual behaviour, with empirical support. This paper explores the theory of optimal income taxation under uncertainty when individuals behave according to the tenets of prospect theory. It is seen that many of the standard results are modified in interesting ways. The first-order approach for solving the optimisation problem is not valid over the domain of losses, and the marginal tax schedule offers full insurance around the reference consumption level. The implications of non-welfarist objectives under income uncertainty are also examined.

Suggested Citation

Kanbur, Ravi and Pirttila, Jukka and Tuomala, Matti, Moral Hazard, Income Taxation and Prospect Theory. Scandinavian Journal of Economics, Vol. 110, No. 2, pp. 321-337, June 2008. Available at SSRN: https://ssrn.com/abstract=1167550 or http://dx.doi.org/10.1111/j.1467-9442.2008.00541.x

Ravi Kanbur (Contact Author)

Cornell University ( email )

301-J Warren Hall
Ithaca, NY 14853
United States
607-255-7966 (Phone)
607-255-9984 (Fax)

HOME PAGE: http://www.kanbur.dyson.cornell.edu

Centre for Economic Policy Research (CEPR)

London
United Kingdom

IZA Institute of Labor Economics

P.O. Box 7240
Bonn, D-53072
Germany

Jukka Pirttila

United Nations - World Institute for Development Economics Research (UNU/WIDER) ( email )

Katajanokanlaituri 6B
Helsinki, FIN-00160
Finland

Tampere University of Technology ( email )

P.O. 541, Korkeakoulunkatu 8 (Festia building)
Tampere, FI-33101
Finland

Matti Tuomala

University of Tampere ( email )

P.O. Box 607
Tampere, FIN-33101
Finland
+358-3-2156031 (Phone)
+358-3-2157254 (Fax)

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