Mental Accounting, Loss Aversion, and Tax Evasion: Theory and Evidence

The evidence shows source-dependent entitlement to income sources and individuals arereluctant to part with income they feel more entitled to, e.g., earned labor income. Taxpayersmay also be more reluctant to part with tax payments (evade more) from income sources theyfeel more entitled to- a form of mental accounting. We embed two main hypotheses within arigorous theoretical model based on prospect theory. From incomes sources they feel moreentitled to, taxpayers experience (i) greater loss aversion from paying taxes, and (ii) lower moralcosts of evasion. We confirm the predictions of our model through MTurk experiments. Evasionis increasing in the tax rate and decreasing in the audit penalty. Moral costs influence taxpayers’decisions. Loss aversion, measured “directly” for the first time for each individual in an evasionexperiment, reduces evasion, as predicted by our theory. Loss aversion, risk aversion, and theirinteraction, are critical determinants of evasion.