Mental Accounting and Tax Compliance

Abstract

Taxes are a burdensome and tedious issue for self-employed who have just started their business. The present research suggests mental accounting as a measure for self-employed to keep track of their financial activities. Based on prospect theory, we argue that the mental segregation of taxes due from net income affects a taxpayer’s reference point in the compliance decision and results in higher tax compliance. Findings from a laboratory experiment confirm this prediction. Further, we show that relevance of mental tax accounting is higher when the tax due is not specified externally as it is the case in pay slips provided to employees. The individual tendency toward mental segregation of tax due and net income is positively related to the sex and age of respondents, their attitudes toward taxpaying, and their experiences gathered in the course of the experiment.