Health Risk and the Welfare Effects of Social Security

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 facing labor income, mortality, and health risks, 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) cutting Social Security's payroll tax, and (ii) modifying the progressivity of the Social Security benefit-earnings rule. We find that both experiments have a larger effect on overall welfare when health risk is present in the model, compared to when health risk is absent. This is because the presence of health risk increases the importance of short-term consumption smoothing-an important channel of self-insurance, and Social Security interferes with this channel. We also find that health risk is important in showing that less progressive pension systems disproportionately hurt the poor. Finally, we show that our welfare results are not sensitive to the degree of risk aversion used in our computations, or to the elasticity of households' labor choice.