Health Risk, Insurance and Optimal Progressive Income Taxation

Abstract

We study the optimal progressivity of personal income taxes in a general equilibrium overlapping
generations model where individuals are exposed to idiosyncratic shocks to labor productivity and health
status over the lifecycle. Our results—based on a calibration to the US economy—indicate that both,
the presence of health risk and the available insurance institutions have a strong effect on the optimal
level of tax progressivity. Given the fragmented and non-universal health insurance system in the US,
a welfare maximizing income tax system is substantially more progressive than the current US income
tax. The higher progressivity provides additional redistribution and social insurance, especially for
unhealthy low income individuals who have limited access to health insurance. When exposure to health
risk is removed or reduced by introducing more comprehensive health insurance systems, we observe
large decreases in the optimal level of income tax progressivity and the optimal tax system resembles
findings from the previous literature. These findings highlight the importance of accounting for the
unique characteristics of health risk and the design of the health insurance system when characterizing
optimal income taxes.

Keywords: Health and Income Risks, Inequality, Social Insurance, Tax Progressivity, Suits Index, Optimal Taxation, General Equilibrium

JEL Classification: E62, I13, H24, D52