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Designing Optimal Unemployment Insurance


Title: Hur ser en optimal arbetsl shetsf rs kring ut? Author: Bertil Holmlund Last modified by: Bertil Holmlund Created Date: 5/23/2004 1:38:04 PM – PowerPoint PPT presentation

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Title: Designing Optimal Unemployment Insurance

Designing Optimal Unemployment Insurance
  • Bertil Holmlund
  • Department of Economics
  • Uppsala University

  • Unemployment benefits around the world
  • Why public UI?
  • Theoretical background
  • Optimal UI
  • Time limits of benefit receipt
  • Monitoring and sanctions
  • Workfare
  • The financing of UI
  • UI savings accounts
  • Conclusions

Unemployment benefits around the world
  • Unemployment insurance (UI)
  • Mainly in developed countries
  • Typically mandatory
  • Percent of past wage (up to a ceiling)
  • Time limited
  • Severance pay
  • One-time payment
  • Collective agreements or mandated by govts
  • Depend on years of service

Unemployment benefits around the world, cont.
  • Unemployment assistance (UA)
  • Minimum income guarantee
  • Often without time limit
  • Sometimes means tested
  • Social assistance
  • Means tested, directed at poor in general
  • Unemployment insurance savings accounts (UISA)
  • Forced savings in individual savings accounts
  • Surplus at retirement age converted into
    retirement income

Why public UI?
  • Informational asymmetries
  • Moral hazard (hidden action)
  • Adverse selection (hidden characteristics)
  • Macro shocks private insurance cannot deal with
    economic slumps
  • Public UI an instrument for stabilization policy

Theoretical background Effects of time limits in
  • Seminal paper Mortensen (1977)
  • Sequential search
  • Maximization of lifetime utility
  • Fixed duration of benefit payments
  • Stochastic duration of employment spells
  • Eligibility condition
  • work must precede benefit receipt

Effects of time limits in UI
  • The reservation wage declines as the insured
    worker gets closer to the date at which benefits
  • The exit rate increases with elapsed duration

  • Job finding over the spell of unemployment

Exit rate
Benefits exhausted
Benefit period
Benefits expire
  • The theory implies that a rise in the benefit
  • increases exit rates to employment among workers
    not eligible for UI (entitlement effect)
  • causes a newly unemployed worker to increase the
    reservation wage
  • but induces an insured worker close to benefit
    expiration to reduce the reservation wage

  • Effects of a rise in the benefit level

Exit rate
Higher benefits
Entitlement effect
Benefits exhausted
  • Strong empirical evidence on the impact of the
    potential duration of benefits
  • Job finding increases as the worker gets closer
    to benefit expiration

Time limited UI and job finding in Sweden
  • Strong empirical evidence on the impact of the
    potential duration of benefits
  • Job finding increases as the worker gets closer
    to benefit expiration
  • Not much evidence on entitlement effects

Optimal UI Time limits
  • Seminal paper Shavell and Weiss (1979)
  • a case for declining time profile
  • A wage tax as complement Hopenhayn and Nicolini
  • Benefits should decrease over the elapsed
    duration of unemployment
  • The wage tax should increase with the length of
    the previous unemployment spell
  • Numerical examples large welfare gains, high
    replacement rates

  • Endogenous work effort Wang and Williamson
  • Endogenous inflow into unemployment the
    probability of remaining employed is increasing
    in work effort.
  • Endogenous outflow from unemployment depends on
    search effort
  • Implications for optimal UI
  • A large drop in consumption in the first period
    of unemployment (discourages shirking)
  • A large reemployment bonus (encourages search)
  • Optimal UI compensation increases initially and
    then falls throughout the spell

Collective bargaining in general equilibrium
Cahuc and Lehmann (1997, 2000)
  • The fall-back position of the union is the
    welfare of the short-term unemployed
  • A declining time profile increases the welfare of
    the short-term unemployed relative to the
    long-term unemployed
  • and may therefore increase wage pressure and

Search equilibriumFredriksson and Holmlund
  • Endogenous search effort, wage bargaining
  • Two states of unemployment
  • Insured (I) and Non-insured (N)
  • Stochastic benefit duration
  • Benefit entitlement through employment

Labor market flows
Value functions for Insured, Non-insured and
Employed worker

  • Welfare objective expected utility of the worker
  • Is a two-tiered benefit system better than a
    uniform one?
  • Yes, in general
  • Entitlement effect benefit differentiation
    encourages search among those who have run out of
  • The welfare improvement relative to a uniform
    system is non-trivial

Summary time profile
  • A reasonably strong case for a declining time
  • A case for a waiting period?
  • Discourage shirking
  • Discourage temporary layoffs
  • Private savings as a substitute

Monitoring and sanctions
  • In practice UI systems condition benefits on
    performance criteria
  • availability for work
  • actively searching for work
  • Monitoring through benefit administration (public
    employment service).
  • Benefit sanctions if search criteria are not met

Monitoring and sanctions in UI theoryBoone
-van Ours (2006) Boone, Fredriksson, Holmlund ,
van Ours (2007)
  • Search and matching model
  • Search effort affects
  • the job finding rate
  • the risk of a benefit sanction

Value function for Insured worker,monitoring and
  • FOC for optimal search, insured worker

Monitoring and sanctions in UI theory
  • Monitoring and sanctions represent a welfare
    improvement for reasonable values of monitoring
  • Boone, Fredriksson, Holmlund, van Ours (2007)

Evidence on monitoring and sanctions
  • Social experiments in the United States
  • Random assignments of unemployed benefit
    claimants into groups exposed to different search
  • Washington state, 1986-87
  • Maryland, 1994

  • The Washington study
  • Treatments
  • Varying degrees of work-search requirements
  • Results
  • Workers without search requirements had 3 weeks
    longer duration of benefit receipt than those
    with standard requirements

  • The Maryland study
  • Treatments increased search requirements
  • An increase in the number of required employer
    contacts from 2 to 4 reduced the duration of
    benefit receipt by 6
  • Informing claimants that their employer contacts
    would be monitored reduced the duration of
    benefit receipt by 7.5

Other experimental evidence
  • Dolton, ONeill (1996), UK
  • Risk of losing benefit if not showing up at
  • Fairly strong increase in the exit rate (30 )
  • Ashenfelter, Ashmore, Deschenes (1999), USA
  • Stricter job search requirements
  • At most very small effect
  • Van den Berg, van der Klaauw (2001), Netherlands
  • Counseling and monitoring
  • No effect on the transition rate from
    unemployment to employment

  • Non-experimental evidence on sanctions
  • How does a sanction affect job finding?
  • Abbring, van den Berg, van Ours (2005),
  • Van den Berg, van der Klaauw, van Ours (2004)
  • Increase in the transition rate to employment by
  • Lalive, van Ours, Zweimuller (2005)
  • Swiss evidence on the impact of warnings and
    actual benefit sanctions
  • Increase in the outflow from unemployment

Workfare work required in exchange for benefits
  • Three arguments
  • Benefits for the unemployed more politically
  • Workfare as a tax on leisure
  • Workfare as a screening device

Workfare and UI
  • Informal argument active labor market policy as
  • Workfare puts a price on workers time
  • Workers with a high value of leisure self-select
    out of the benefit system
  • Formal modeling, example
  • Two types of individuals, different preferences
    for leisure
  • The government doesnt know individual
    preferences, only the distribution
  • Kreiner and Tranaes (2005), Fredriksson and
    Holmlund (2006)

  • Can workfare be Pareto improving?
  • Yes!
  • Absent workfare, searching as well as
    non-searching individuals may claim benefits
  • Workfare induces non-searching workers to
    self-select out of UI (strong preference for
  • Makes it possible to raise benefits without
    making it worse for non-searching individuals

Evidence on workfare
  • Black, Smith, Berger, Noel (2003), USA
  • Random assignment into mandatory employment and
    training services
  • Participation required in order to receive
  • Results
  • A reduction in the mean UI duration by about 2
  • A marked rise in reemployment before the
    scheduled program participation

The financing of UI
  • Current systems
  • Taxes
  • (Incomplete) experience rating on firms (USA)
  • Alternatives
  • Taxes on workers that depend on their
    unemployment experiences
  • (cf. unemployment insurance savings accounts)
  • More stringent experience rating

Pros and cons of experience rating
  • ER discourages layoffs
  • But firms have not much influence over workers
    search and job finding
  • ER is effectively on tax on layoffs and thereby
    indirectly also a tax on hirings
  • Many countries already tax layoffs through
    employment protection legislation (EPL)
  • Optimal mix of ER and EPL?

Unemployment insurance savings accounts
Feldstein-Altman (1998), Bovenberg-Sorensen
(2004), Stiglitz -Yun (2005)
  • Mandatory savings of wage income into an
    unemployment insurance account (UISA)
  • Job loss withdraw from the account
  • If funds are insufficient, borrow from the
  • At retirement age convert UISA into retirement
  • The government cancels the debt if the balance is

Pros and cons of UISA
  • UISA reduces moral hazard problems
  • The worker finances her own benefits
  • UISA allows borrowing against future income
  • Some workers will retire with negative balances
  • How common?
  • Rules for withdrawal
  • Worker heterogeneity and distributional issues

  • The case for penalizing less active search is
  • Indirect penalty a declining time profile
  • More direct penalty via monitoring of search
  • Workfare can be a useful screening device
  • Caveats
  • Low benefits during the first week(s) would
    discourage unemployment entry
  • Precautionary savings
  • UISA may be a useful complement to UI