Moral Hazard, Income Taxation and Prospect Theory

Scandinavian Journal of Economics, 110(2):321-337. (2008) DOI: 10.1111/j.1467-9442.2008.00541.x

Posted: 6 Sep 2014

See all articles by Jukka Pirttila

Jukka Pirttila

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

Ravi Kanbur

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

Matti Tuomala

University of Tampere

Multiple version iconThere are 2 versions of this paper

Date Written: January 2008

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.

Note: Copyright © The editors of the "Scandinavian Journal of Economics" 2008.

Keywords: Redistributive taxation; income uncertainty; moral hazard; prospect theory; loss aversion

JEL Classification: D81, H21

Suggested Citation

Pirttila, Jukka and Kanbur, Ravi and Tuomala, Matti, Moral Hazard, Income Taxation and Prospect Theory (January 2008). Scandinavian Journal of Economics, 110(2):321-337. (2008) DOI: 10.1111/j.1467-9442.2008.00541.x. Available at SSRN: https://ssrn.com/abstract=2491790

Jukka Pirttila (Contact Author)

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

Ravi Kanbur

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

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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