Optimal commodity taxation with moral hazard and unobservable outcomes

The optimal public insurance-taxation scheme is derived for a model with unobservable outcomes. If the government can only observe aggregate commodity expenditures, reimbursement insurance is constrained-efficient. However, two distortions accompany the reimbursement scheme. First, consumers are induced to take (forego) actions which increase (decrease) the likelihood of adverse outcomes (i.e., ex ante moral hazard). Second, reimbursement insurance creates a subsidy distortion (i.e., ex post moral hazard). Ex ante moral hazard calls for taxation (subsidization) of commodities which increase (decrease) the probability of adverse outcomes. The second distortion calls for taxation (subsidization) of commodities which are sufficiently strong complements to (substitutes for) the insured commodity. An example centered on cigarettes and medical insurance is presented.