The welfare effect of income tax deductions for losses as insurance: Insured- versus insurer-sided adverse selection

Kaplow (1992) shows in a complete-information environment that allowing income tax deductions for losses as partial insurance is undesirable in the presence of private insurance markets. This paper elaborates on Kaplow's finding by studying two extreme types of asymmetric information structures in private insurance markets: Either the insured or insurers possess superior information. It is shown that our derived result is consistent with Kaplow's if the insured have superior information; however, Kaplow's negative conclusion with respect to the income tax deduction will be overturned if insurers have superior information instead. A policy implication from our finding is that whether or not to allow an income tax deduction for losses needs to be more refined and, specifically, it should be tailored to the “adverse selection” information structures of private insurance.

► The model is based on Rothschild and Stiglitz (1976). ► We focus on two extreme kinds of “adverse selection” information structures. ► We focus on the separating contract. ► Income tax deduction will be allowed if insurers have superior information. ► Income tax deduction will be rejected if the insured have superior information.