Health risk and the welfare effects of Social Security

Abstract

Abstract 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 US economy and perform two computational experiments: $\left (i\right)$ cutting Social Security’s payroll tax, and $\left (ii\right)$ modifying Social Security’s benefit-earnings rule. Our findings suggest that health risk amplifies the welfare implications of both experiments: downsizing Social Security always leads to higher overall welfare, but the welfare gain is larger when we account for health risk, and increasing the progressivity of Social Security’s benefit-earnings rule has a larger positive effect on welfare in the presence of health risk. We also find that allowing households additional tools to self-insure against health risk weakens the precautionary motive, so our experiments have similar welfare implications both with and without health risk.