Sick Pay Policies and the Socioeconomic Gradient in Health and Welfare

Sick pay compensates for income loss during illness, but its distributional and efficiency effects depend fundamentally on how it is financed. We develop a dynamic general equilibrium model with endogenous health investment and biologically founded interactions between acute illness and chronic health deficits to study how the generosity and financing of sick pay affect equilibrium wages, health inequality, income distribution, life expectancy, and welfare. Calibrating the model to Germany, we show that reducing the replacement rate under employer-financed sick pay widens health and income disparities across education groups while, through behavioral responses, slightly increasing average life expectancy. The reform may nevertheless impose substantial welfare losses on individuals with comparatively high sickness absence. By contrast, publicly financed sick pay redistributes across education groups while eliminating wage distortions arising from employer financing, thereby reducing health and income disparities. Consequently, low-skilled workers typically prefer publicly financed sick pay, whereas high-skilled workers prefer employer-financed sick pay.