We study optimal social insurance aimed at insuring disability risk in the presence of linear income taxation. Optimal disability insurance benefits rise with previous earnings. Optimal insurance is incomplete even though disability risks are exogenous and verifiable so that moral hazard in disability insurance is absent. Imperfect insurance is optimal because it encourages workers to insure themselves against disability by working and saving more, thereby alleviating the distortionary impact of the redistributive income tax on labor supply and savings.
Scandinavian Journal of Economics, 2009, Vol 111, Issue 2, p. 251-275
Faculty of Social Sciences; disability insurance; optimal taxation; moral hazard; redistribution; labor supply; skill groups