Optimal Income Tax Enforcement under Prospect Theory

Prospect theory (PT) has become the most accepted alternative to expected utility theory (EUT) as a theory of decision under uncertainty. This paper extends the existing literature on efficient tax and audit schemes, by answering the question as to just how progressive an efficient tax system can be when assuming that taxpayers behave in line with the tenets of PT. Under reasonable assumptions regarding the reference income and the value function of taxpayers, we show that the efficient tax schedule is regressive while audit probabilities are nonincreasing in the declared income. These results are consistent with the previous literature on EUT.