A Prospect Theory Account of the Income Tax Withholding Phenomenon

Abstract Actual taxpayer return data indicate the presence of a "withholding phenomenon"-taxpayers who are underwithheld at filing exhibit lower rates of compliance than those who are overwithheld. Contemporary theories of taxpayer compliance based on the expected utility hypothesis have not explained this phenomenon. The present research tests an explanation, based on prospect theory principles, which posits that taxpayers′ withholding position differentially affects their risk attitudes. This explanation assumes that the current asset position, rather than the expected asset position, better represents the reference point taxpayers use to evaluate tax-related outcomes. Experimental results favor the former as the reference outcome that better represents what taxpayers tend naturally to employ when making tax reporting decisions. These results support the explanation of the withholding phenomenon based on differing risk attitudes induced by being over- or underwithheld at filing.