ABSTRACT

Based on prospect theory's value function, we predict how reference points adapt to influence individuals' tax evasion choices during and after experiencing temporary tax changes. Results from a multi-round experiment indicate reactions to temporary changes depend jointly on the direction of the change and expectations. Specifically, individuals experiencing a tax increase evade more while the increase is in effect. More interestingly, knowing, versus not knowing, a tax decrease is temporary prevents an increase in evasion after the temporary change expires, and may lead individuals to reduce evasion during the change. In a supplemental condition, we induce uncertainty by repeatedly extending a tax decrease. We find when uncertainty is introduced, both benefits of knowing the temporal nature of the decrease are lost. Overall results are consistent with individuals failing to adapt to a loss state and adapting quickly to a gain state unless they are certain the gain state is temporary.

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