Prospect theory and tax evasion: a reconsideration of the Yitzhaki puzzle

Amedeo Piolatto; Matthew D Rablen

doi:10.1007/s11238-016-9581-9

Prospect theory and tax evasion: a reconsideration of the Yitzhaki puzzle

Theory Decis. 2017;82(4):543-565. doi: 10.1007/s11238-016-9581-9. Epub 2016 Nov 14.

Authors

Amedeo Piolatto¹, Matthew D Rablen²

Affiliations

¹ 1Barcelona Economics Institute (IEB), University of Barcelona, c/ J. M. Keynes, 1-11, 08034 Barcelona, Spain.
² 2Department of Economics, University of Sheffield, 9 Mappin Street, Sheffield, S1 4DT UK.

Abstract

The standard expected utility (EUT) model of tax evasion predicts that evasion is decreasing in the marginal tax rate (the Yitzhaki puzzle). Recent literature shows cases in which incorporating prospect theory (PT) does and does not overturn the Puzzle. In a general environment that nests both PT and EUT preferences, we provide a detailed study of how the elements of PT affect the Puzzle. PT does not always reverse the Puzzle, hence we give and interpret conditions for when it does and does not. When allowing for stigma and/or variable audit probability, PT reverses the Puzzle in the same way and with the same limitations as does EUT, if equally augmented.

Keywords: Diminishing sensitivity; Endogenous reference level; Prospect theory; Reference dependence; Stigma; Tax evasion; Variable audit probability; Yitzhaki puzzle.