Solving the Yitzhaki Paradox: Income Tax Evasion and Reference Dependence under Prospect Theory

Gwenola Trotin (1)

1 GREQAM - Groupement de Recherche en Économie Quantitative d'Aix-Marseille

This paper examines the determinants of tax evasion under prospect theory. For prospect theory, reference dependence is a fundamental element (the utility function depends on gains and losses relative to a reference point and not on final wealths as in expected utility theory). In order to identify the determinants of the income tax evasion decision, a general reference income is used. We show that results obtained under expected utility theory are not robust. In particular, tax evasion is increasing in the tax rate as soon as a suitable relative risk aversion measure is larger with auditing, than without. With this simple and testable condition, prospect theory provides a general framework consistent with empirical evidence for the tax evasion behaviour problem.

Keywords: Decision weights; Tax evasion; Prospect theory; Reference dependence

Domains: Economics and Finance

Gwenola Trotin. Solving the Yitzhaki Paradox: Income Tax Evasion and Reference Dependence under Prospect Theory. 2012. ⟨halshs-00793664⟩