Optimal Income Tax Enforcement under Prospect Theory

• DOI: http://doi.org/10.1111/jpet.12143
• Author: AMEDEO PIOLATTO,GWENOLA TROTIN
• Date: 01 February 2016
• Published date: 01 February 2016

OPTIMAL INCOME TAX ENFORCEMENT UNDER PROSPECT THEORY

AMEDEO PIOLATTO

Barcelona Economics Institute

GWENOLA TROTIN

Aix-Marseille School of Economics

Abstract

Prospect theory (PT) has become the most accepted alternative to ex-

pected utility theory (EUT) as a theory of decision under uncertainty.

This paper extends the existing literature on efficient tax and audit

schemes, by answering the question as to just how progressive an effi-

cient tax system can be when assuming that taxpayers behave in line

with the tenets of PT. Under reasonable assumptions regarding the ref-

erence income and the value function of taxpayers, we show that the

efficient tax schedule is regressive while audit probabilities are nonin-

creasing in the declared income. These results are consistent with the

previous literature on EUT.

1. Introduction

Recent advances in behavioral economics have shown the limitations of expected utility

theory (EUT) for predicting agent behavior, and forward prospect theory (PT) as a

more consistent alternative with observed data.1

Assuming agents behave in accordance with the tenets of PT requires verification of

the robustness of previous results. Within the taxation literature, Kanbur, Pirttil¨

a, and

1PT (Kahneman and Tversky 1979; Tversky and Kahneman 1981) has been extensively used in eco-

nomics over the last two decades (Camerer 2000; Camerer and Loewenstein 2003; Barberis 2013). Neil-

son and Stowe (2002) discuss its limitations. Masatlioglu and Raymond (2014) discuss and compare PT

with other reference-dependent models. List (2004), Post et al. (2008), Bruhin, Fehr-Duda, and Epper

(2010), Conte, Hey,and Moffatt (2011) provide evidence that agents’ behavior is often better explained

by PT than it is by EUT.

Amedeo Piolatto, Barcelona Economics Institute, University of Barcelona, c/Tinent Coronel Valen-

zuela, 1-11, 08034 Barcelona, Spain (piolatto@ub.edu). Gwenola Trotin, Aix-Marseille School of Eco-

nomics, CNRS & EHESS (gwenola.trotin@univ-amu.fr).

The project was started at Toulouse School of Economics: we thank all members for their sugges-

tions, help, and comments. For their comments and discussions, we are particularly indebted to A.

Al-Nowaihi, M. Bernasconi, T. Gajdos, M. Jeleva, M. Le Breton, J. Pirttil¨

a, M. Rablen, A. Rees-Jones,

M. Tuomala, and A. Trannoy. We are also grateful to the editor J. P. Conley, and the anonymous asso-

ciate editor and referee for their helpful comments. Piolatto acknowledges financial support from the

Spanish Ministry of Science and Innovation (grant ECO/2012-37131) and the Generalitat de Catalunya

(2014SGR420).

Received October 19, 2014; Accepted October 20, 2014.

C2014 Wiley Periodicals, Inc.

Journal of Public Economic Theory, 18 (1), 2016, pp. 29–41.

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