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

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