Optimal sickness benefits in a principal-agent model

This paper studies the optimal design of sickness benefits in a repeated principal-agent model, where the fraudsters are not observed by the principal. Sickness compensation protects workers against the income fluctuations implied by the risk of illness and its provision is limited by the presence of fraudsters using this protection to temporarily adjust their labour supply. We show that the slope of the optimal contract depends on the dynamics of the rate of fraudsters over time. When the duration of temporary shocks on the disutility of work is shorter than the average duration of diseases, the sickness benefits must increase over time. In addition, A tax dependent on the length of the sick leave makes it possible to minimise the cost for a given promise-keeping constraint. Contrary to intuition, this tax must be decreasing because the necessity to penalise the shortest sick leave to deter agents from cheating.