Health Shocks and the Evolution of Earnings over the Life-Cycle

Abstract

We study the contribution of health shocks to earnings inequality and uncertainty in labor market outcomes. We calibrate a life-cycle model with idiosyncratic health, earnings, employment and survival risk, where individuals make labor supply and savings decisions, adding two novel features. First, we model health as a complex multidimensional concept. We differentiate between functional health and latent health risk, and between temporary/persistent and predictable/unpredictable health shocks. Second, we model interactions between health and human capital accumulation. We find that, in an environment with both costly health shocks and means-tested transfers, low-skill workers find it optimal to reduce their labor supply in order to maintain eligibility for transfers that protect them from potentially high health care costs. Thus, means-tested transfers generate a moral hazard effect that causes agents (especially those with low productivity) to invest less in human capital. Provision of public insurance can alleviate this problem and enhance labor supply.