Optimal Taxation and Social Insurance with Endogenous Private Insurance

This paper characterizes the welfare gains from government intervention when the private sector provides partial insurance. We analyze models in which adverse selection, preexisting information, or imperfect optimization in private insurance markets create a role for government intervention. We derive simple formulas that map existing empirical estimates into quantitative predictions for optimal policy. When private insurance generates moral hazard, standard formulas for optimal government insurance must be modified to account for fiscal externalities. In contrast, standard formulas are unaffected by “informal” private insurance that does not generate moral hazard. Applications to unemployment and health insurance show that taking formal private market insurance into account matters significantly for optimal benefit levels given existing empirical estimates of the key parameters. ∗E-mails: [email protected], [email protected]. We thank Andrew Clark, Amy Finkelstein, Roger Gordon, Ken Judd, Narayana Kocherlakota, Pierre Pestieau, Thomas Piketty, NBER TAPES conference participants, and an anonymous referee for very helpful comments and discussions. Financial support from NSF Grant SES-0134946 and the Sloan Foundation is gratefully acknowledged.