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The economic effects of nonlinear health dynamics: estimates from a dynamic life-cycle model

We study how nonlinear, state-dependent health dynamics shape economic behavior, inequality, and the evaluation of disability insurance at older ages. Using English panel data, we construct a continuous health index and estimate its dynamics with a flexible quantile-based method that allows persistence to vary across health states. We find that adverse health realizations are both larger and more persistent among individuals in poor health. Embedding the estimated process into a life-cycle model, we show that these state-dependent nonlinearities generate substantial losses in assets and welfare for economically vulnerable individuals-those with poor health and low wealth. Misspecifying health dynamics as state-independent attenuates these losses and leads to distorted savings behavior, with effects concentrated among vulnerable individuals. Finally, we find that the welfare losses of removing disability insurance are highly heterogeneous across health types, and are overstated by a state-independent health process.