Mental Accounting and the Impact of Tax Penalty and Audit Frequency on the Declaration of Income: An Experimental Analysis

We investigate (i) whether traders on an experimental asset market form different and separate mental accounts for sale revenues and for dividend earnings and whether (ii) an increase in tax penalty or (iii) an increase in audit frequency increases tax compliance. The results indicate that participants did not form separate mental accounts for sale revenues and for dividend earnings. However in line with prospect theory, it can be shown that a purchase of assets is perceived as a subjective loss that one tries to "repair" by risk seeking behavior. Participants who increased their net asset holdings declared less income to the tax authorities. Furthermore, the results indicate that an increase in tax penalties as well as an increase in audit frequency increased compliance. In addition, it was found that tax compliance was lower after an audit, especially after the first audit, and that it was lower for participants with high incomes.