Optimal Disability Insurance and Unemployment Insurance with Cyclical Fluctuations
40 Pages Posted: 26 Mar 2016
Date Written: March 19, 2016
This paper studies the optimal joint design of disability insurance and unemployment insurance in an environment with moral hazard, when an individual’s health status is private information, taking into account cyclical fluctuations. I first show how disability benefits and unemployment benefits vary with aggregate economic conditions in an optimal contract that resolves this information problem. I then consider a calibrated version of the model and study the quantitative implications of changing from the current system to the optimal one. Last, in a special case, I demonstrate that the optimal joint insurance system can be implemented using a relatively simple model: by allowing workers to save or borrow using a bond and by providing flow payments and lump-sum transfers/payments, where the interest rates and the amounts paid/transferred depend on the employment or health status of the agent and the state of the economy. In the optimal system, disability benefits are designed such that the system punishes workers who stay unemployed for a long time, reducing the unemployment rate by roughly 40 percent and incurring substantial cost savings from resolving incentive problems. Using the model to implement the optimal system, I am able to analyze in details the driving forces behind the differences between the current system and the optimal system Under the optimal joint design of these insurance programs, disability insurance serves as an additional tool for the government to provide incentives for the job search. Reductions in unemployment rates and substantial cost savings can be achieved if the optimal system is adopted.
Suggested Citation: Suggested Citation