Health Shocks and the Evolution of Consumption and Income over the Life-Cycle

This paper studies the effects of health on earnings dynamics and on consumption inequality over the life-cycle. We build and calibrate a life-cycle model with idiosyncratic health, earnings and survival risk where individuals make labor supply and asset accumulation decisions, adding two novel features. First, we model health as a complex multi-dimensional concept. We differentiate between functional health and underlying health risk, temporary vs. persistent health shocks, and predictable vs. unpredictable shocks. Second, we study the interactions between health and human capital accumulation (learning-by-doing). These features are important in allowing the model to capture the degree to which, and the pathways through which, health impacts earnings and consumption patterns. They are also very important in estimating the value of health insurance and social insurance. A key finding is that health shocks account for roughly half of the growth in offer wage inequality over the life cycle. Eliminating health shocks leads to a 5.5% decline in the variance of the present value of earnings across all individuals.