Health Risk and the Welfare Effects of Social Security

We quantify the importance of idiosyncratic health risk in a calibrated general-equilibrium model of Social Security. We construct an overlapping-generations model with rational-expectations households, idiosyncratic labor income and health risk, profit-maximizing firms, incomplete insurance markets, and a government that provides pensions and health insurance. We calibrate this model to the U.S. economy and perform two sets of computational experiments: (i) we decrease the size of Social Security, and (ii) we modify the progressivity of Social Security's benefit-earnings rule. We find that cutting Social Security's payroll tax in general equilibrium increases overall welfare, but by a lesser extent when health risk is present. When we modify the progressivity of Social Security's benefit-earnings rule, we find that a lump-sum benefit unrelated to past income increases overall welfare, but by a larger extent in the presence of health risk. A linear (fully proportional) benefit-earnings rule, on the other hand, reduces overall welfare, but also by a larger extent in the presence of health risk. Together, our results suggest that Social Security's implicit insurance is more valuable for low- and medium-income households when health risk is present in the model environment.