Optimal Disability Insurance with Unobservable Skill Heterogeneity

This paper studies the optimal disability insurance in a dynamic Mirrlees economy with idiosyncratic labor productivity. Agents in each period face labor productivity and permanent disability shocks, which are both private information. I show that the “no distortion at the top” principle does not hold, due to the incentive for low productivity agents to declare that they are high-skilled and disabled. To quantify the welfare gains of the policy change to the optimal allocation, I compute the equilibrium allocation under the US income tax and disability insurance system and compare it with the optimal allocation for a calibrated version of the economy. The policy change improves the welfare significantly and yields the same welfare gains as a 3.9% of consumption increase for each agent under the current US system. Reduced consumption inequality and more efficient labor allocation in the optimal allocation account for the welfare gains.