Optimal Health Insurance and the Distortionary Effects of the Tax Subsidy

29 Pages Posted: 6 Feb 2013 Last revised: 17 Apr 2013

Date Written: December 19, 2012


This paper introduces a model of optimal health insurance. This model provides theoretical guidance of the relationship between household preferences, cost-sharing, and premiums. It applies this model to understand how the income tax subsidy distorts optimal cost-sharing in health insurance. Typically, insurance protects individuals from financial risk. Health insurance plans, however, are frequently designed to provide coverage at non-catastrophic levels of financial loss. The presence of a health insurance subsidy in the United States tax code, which enables individuals to pay premiums in pre-tax dollars, encourages the purchase of more generous health insurance plans. Little is known about how the tax subsidy affects preferences for the structure of cost-sharing in private plans. This model illustrates how the tax subsidy can distort the optimal cost-sharing schedule. The model is tested empirically using claims data in the Medical Expenditure Panel Survey and a regression discontinuity strategy that uses discrete changes in the marginal tax rate at the Social Security taxable maximum for identification.

Keywords: optimal health insurance, income taxes, cost sharing

JEL Classification: H24, H31, I13

Suggested Citation

Powell, David, Optimal Health Insurance and the Distortionary Effects of the Tax Subsidy (December 19, 2012). RAND Working Paper Series WR- 975. Available at SSRN: https://ssrn.com/abstract=2212484 or http://dx.doi.org/10.2139/ssrn.2212484

David Powell (Contact Author)

RAND Corporation ( email )

1776 Main Street
P.O. Box 2138
Santa Monica, CA 90407-2138
United States

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