Optimal taxation in the presence of tax evasion: Expected utility versus prospect theory

Abstract

Abstract It is now well known that the predictions of expected utility theory (EUT) applied to tax evasion are quantitatively and qualitatively at variance with the evidence while prospect theory (PT) makes the correct predictions. In this literature, the tax rate is exogenous. We endogenize the tax rate, and require that a successful theory should explain, jointly, the facts on the tax rate, tax gap and the level of government expenditure. We find that the data is best described by taxpayers using PT and the government using standard utility theory, EUT. The results are robust to several possible alternative specifications. We discuss how our results have a bearing on the debate between liberalism versus paternalism in behavioral economics. We also propose an alternative explanation based on the notion of context dependent preferences.