Redistributing to the sick: How should health expenditures be integrated into the tax system?

I study the optimal joint taxation of income and health expenditures in a model in which individuals face idiosyncratic prices for leisure and health. First-best redistribution based on potential wage rates and health status is not feasible. Within a class of quasi-linear schedules, the conditions for an optimal tax/subsidy system depend on the own and cross price compensated elasticities of demand for leisure and health in a way that generalizes the standard results from the optimal linear income tax literature. Numerical simulations are employed to illustrate the sensitivity of tax and subsidy rates to the correlation between health status and wages. In these simulations, the effective marginal income tax rate optimally increases with health expenditures. However, the welfare gain from optimally incorporating health expenditures into the tax system appears to be very limited, compared with the effect of properly designing the income tax itself.