Tax Compliance: A Behavioral Economics Approach

Tax evasion is one of the key challenges for the policy makers. Designing the optimal tax code requires assessment of taxpayers’ compliance behavior. Tax rate, detection intensity, penalty rate - are some of the characteristics considered in models of tax evasion. The central question in tax evasion literature is how changes in fiscal policy parameters affect evasion. The literature on tax evasion can be categorized into two broad groups. The first strand of literature is based on expected utility theory (EU) and the second strand approaches the evasion problem from a behavioral perspective. This dissertation uses a behavioral approach to study tax compliance behavior and contributes to the second group of the literature. The second chapter of this dissertation investigates tax compliance behavior of individuals with reference dependent preferences and endogenous reference point. The results are derived for the three personal equilibrium concepts of Kőszegi and Rabin (2007). The effects of tax policy parameters on compliance are found qualitatively similar to the results under EU. Do taxpayers change their tax compliance behavior after the announcement and before the actual enforcement of a new tax rate? This is the central question of the third chapter. Using cumulative prospect theory framework and a reference point adaptation process, the answer is that evasion in the transition period increases following the announcement of the tax rate reduction or increase. An increase in the tax rate increases evasion, whereas reduction of the tax rate reduces evasion in the long run. The final chapter of this dissertation develops a model of tax compliance behaviour with endogenous social norms. The implications of the model are that the tax policy parameters not only shape monetary (dis)incentives for compliance, but also determine the strength of the social norm of compliance. The social norm of compliance is weaker under the higher tax rate and the norm is stronger under the stricter tax enforcement regime.