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Moral Hazard, Income Taxation and Prospect Theory *
Author(s) -
Kanbur Ravi,
Pirttilä Jukka,
Tuomala Matti
Publication year - 2008
Publication title -
scandinavian journal of economics
Language(s) - English
Resource type - Journals
SCImago Journal Rank - 1.725
H-Index - 64
eISSN - 1467-9442
pISSN - 0347-0520
DOI - 10.1111/j.1467-9442.2008.00541.x
Subject(s) - economics , moral hazard , consumption (sociology) , expected utility hypothesis , order (exchange) , microeconomics , schedule , public economics , mathematical economics , incentive , social science , management , finance , sociology
The standard theory of optimal income taxation under uncertainty has been developed under the assumption that individuals maximise expected utility. However, prospect theory has now been established as an alternative model of individual behaviour, with empirical support. This paper explores the theory of optimal income taxation under uncertainty when individuals behave according to the tenets of prospect theory. It is seen that many of the standard results are modified in interesting ways. The first‐order approach for solving the optimisation problem is not valid over the domain of losses, and the marginal tax schedule offers full insurance around the reference consumption level. The implications of non‐welfarist objectives under income uncertainty are also examined.