Prospect Theory and Tax Evasion: A Reconsideration of the Yitzhaki Puzzle

The standard expected utility model of tax evasion predicts that evasion is decreasing in the marginal tax rate (the Yitzhaki puzzle). Recent literature incorporating prospect theory claims to overturn the puzzle. We re-examine these claims for general specifications of the reference level, and with four distinct elements of prospect theory disentangled. Prospect theory fails to reverse the puzzle for a set of specifications of the reference level that includes the most common specifications in the literature. Loss aversion and probability weighting are redundant in respect of the puzzle. To overturn the puzzle, alternative specifications of the reference level are needed.