Health Risk, Insurance and Optimal Progressive Income Taxation

We study the optimal progressivity of personal income taxes in a general equilibrium overlapping generations model where individuals are exposed to idiosyncratic shocks to health and labor productivity over the lifecycle. Our results—based on a calibration to the US economy—indicate that the presence of health risk and health insurance has a strong effect on the optimal level of tax progressivity. Given the existing non-universal health insurance system in the US, the optimal income tax system is highly progressive in order to provide a sufficient amount of redistribution and social insurance to unhealthy low income individuals. The total welfare gain from optimizing the progressivity level is 5.6 percent in compensating lifetime consumption. The introduction of more comprehensive health insurance systems, such as Medicare for all, leads to large decreases in the optimal level of tax progressivity. When health expenditure risk is not modeled our framework exhibits an optimal income tax system similar to prior literature that abstracts from health risk. These findings highlight the importance of accounting for the unique characteristics of health and health insurance policies when designing optimal income taxes.