Optimal Partial and Full Disability Insurance with an Application to Korea

This paper studies the optimal disability insurance (DI) in a dynamic economy with partial and full disability, which are privately observed. I show that it is optimal to induce partially disabled agents to participate in the labor market unless the labor supply is relatively elastic and their earning capacity is signi…cantly reduced. However, such agents should also be provided with signi…cant government transfer payments since their earnings tend to be small. As an application of the framework, this paper also evaluates DI programs in Korea, which include both partial and full disability bene…ts. In the calibrated model, I …nd that if Korea’s DI programs are replaced with the corresponding optimal system, welfare gains amount to a 1.18% increase in consumption for all agents. Such a reform substantially improves the welfare of both types of disabled agents through large additional transfers but hardly hurts able agents, despite slightly more taxes, because of e¢ ciency gains.