For those who have an opportunity to evade income taxes, the return is about 98%? In actual practice, about 30 percent of those who have an opportunity to evade do actually evade. Thus, one observes far too much compliance relative to the predictions of expected utility theory (EUT) By using the stylized Allingham-Sandmo model, this paper explains observed compliance using Kahneman and Tversky's cumulative prospect theory (PT). We show that an increase in the tax rate leads to an increase in the amount evaded, which is in broad agreement with the evidence but is contrary to the prediction made by expected utility theory. We then go on to consider issues of optimal income taxation when taxpayers can evade. As a benchmark for a successful theory, we impose the restriction that it should explain, jointly, the facts on the tax rate, tax gap and the level of government expenditure. We find that when taxpayers use EUT (respectively, PT) and the optimal tax is derived from a social welfare function that also uses EUT (respectively, PT), then, the calibration results are completely at odds with the facts. However, when taxpayers use PT but the social welfare function uses standard EUT, there is a very close match between the predictions and the facts. This has important implications for context dependent preferences but also for the newly emerging literature on liberalism versus paternalism in behavioural economics.