Optimal disability insurance with unobservable skill heterogeneity☆

a r t i c l e i n f o This paper studies the U.S. income tax and disability insurance systems in a unified framework with relevant private information and a general social welfare function. To that end, I develop a dynamic model in which agents differ in labor productivity and disability status, which are both private information. The optimal allocation can exhibit negative marginal labor income tax rates for high-skilled individuals but zero for low-skilled individuals, which is contrary to standard results. Also, I find that a reform to the optimal system in the calibrated model would significantly improve the U.S. system. The welfare gains amount to a 3.48 percent increase in consumption with a utilitarian social welfare function, which might be larger with a non-utilitarian function. Better insurance for people in bad states and reduced intratemporal distortions account for almost all the welfare gains. However, intertemporal distortions do not appear to play a major role. The Social Security Disability Insurance (SSDI) program is one of the largest social insurance programs in the United States. In 2013, this program provided nearly 11 million people with benefits worth over 140 billion dollars. 1 Because SSDI has grown so much in size and importance , its effectiveness in providing insurance to people with disabilities must be assessed and the possibilities for improving the program analyzed. To address these questions adequately, SSDI must be scrutinized in a dynamic model with uncertain disability shocks and other relevant life-cycle components, and the optimal system should be similarly scrutinized. However, no such analysis has been attempted in the literature on disability insurance, to the best of my knowledge. Moreover, disability insurance has typically been studied in isolation from other tax and social insurance programs 2 ; these analyses might also be insufficient or even misleading if economic shocks that are relevant to other programs are systematically intertwined with disability risk. Thus, it would be desirable to incorporate relevant shocks to the analysis of disability insurance. Motivated by these issues in the literature, this paper provides a comprehensive welfare analysis of the U.S. income tax and disability insurance systems in a dynamic model with private information for both labor productivity and disability. Individuals are either high-skilled or low-skilled throughout their lives, but they can become disabled permanently during any period. However, both their skill types and their disability status are only privately observed. In this …