Tax evasion and Prospect Theory in a OLG economy

This paper presents a simple Overlapping Generation Model (OLG), augmented with Prospect Theory elements in the spirit of al-Nowaihi and Dhami (2007). The model tackle several open questions in the analysis of tax evasion and compliance decisions. In particular, the paper presents a new and complementary approach to address tax compliance decision in a OLG economy with behavioral components. Our main results are the following: there exists an equilibrium with a tax evasion level which can be coherent with the empirical estimates for the US economy; for our calibrations we find that the relationship between the tax rate and the evasion rate is a positive one (i.e., the model offers a solution to the Yitzhaki puzzle); we can highlight the role played in the context of tax evasion by an essential component of Prospect Theory, the framing effect, which was precluded to simple individual choice models.