Loss Aversion and Tax evasion: Theory and Evidence

We consider income-source-dependent tax evasion and show that this is a generalisation of the well-known endowment effect. We show that loss aversion, moral costs, mental accounting and risk preferences play a role in explaining key features of source-dependent tax evasion. We provide evidence of the first direct link between subject-specific loss aversion and tax evasion, which is central to most successful modern theoretical accounts of tax evasion. We provide some evidence that risk aversion strengthens the cautionary effect of loss aversion and risk loving behaviour attenuates, or reverses, it. However, the underlying effect is also influenced by the source of income. Evasion is increasing in the tax rate and decreasing in the audit penalty, as predicted. Our study provides novel theoretical insights; proposes new methods in the estimation of the underlying behavioural parameters; and confirms the central predictions of the theory, while pointing out challenges for further developments that existing theory is unable to account for.