Optimal tax enforcement under prospect theory

Abstract

Prospect Theory (PT) has become the most credited alternative to Expected Utility Theory (EUT) as a theory of decision under uncertainty. This paper characterises the optimal income tax and audit schemes under tax evasion, when taxpayers behave as predicted by PT. Under reasonable assumptions on the reference income and on the utility function of taxpayers, we show that the optimal audit probability function is non-increasing and the optimal tax function is non-decreasing and concave. The conditions under which those results hold for PT are weaker than the corresponding one for EUT.