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

The evidence shows source-dependent entitlement to income sources and individuals are

reluctant to part with income they feel more entitled to, e.g., earned labor income. Taxpayers

may also be more reluctant to part with tax payments (evade more) from income sources they

feel more entitled to- a form of mental accounting. We embed two main hypotheses within a

rigorous theoretical model based on prospect theory. From incomes sources they feel more

entitled to, taxpayers experience (i) greater loss aversion from paying taxes, and (ii) lower moral

costs of evasion. We confirm the predictions of our model through MTurk experiments. Evasion

is 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 evasion

experiment, reduces evasion, as predicted by our theory. Loss aversion, risk aversion, and their

interaction, are critical determinants of evasion.