Mental Accounting and Taxpayer Compliance: Insights into the Referent Point that Separates Honest from Dishonest Behavior

Empirical results grounded in prospect theory shows that taxpayers’ compliance is a function of whether they are in a tax gain or loss position, being more likely to “cheat” when they perceive that they are in a tax loss as compared to tax gain. Nevertheless, what remains to be determined is how taxpayers mentally determine what is a tax loss or a tax gain. We conduct a field experiment when taxpayers are filing actual returns to better determine the actual referent point that separates tax gains from tax losses. We find that mental categorization of taxes paid and owed is critical to taxpayer determination of their referent point, which takes into account what they anticipate they will owe or receive upon filing their tax return. From a theoretical perspective, our research shows that current perceptions of their expected asset position shapes the referent point. From a practical perspective, our findings suggest that taxpayer honesty depends primarily on how they separate tax withholdings from their current net worth.