Designing Optimal Unemployment Insurance

1. Designing Optimal Unemployment Insurance Bertil Holmlund Department of Economics Uppsala University

2. Outline • 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

3. 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 gov’ts • Depend on years of service

4. 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

5. 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

6. Theoretical background Effects of time limits in UI 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

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

8. Exit rate Job finding over the spell of unemployment Benefit period Benefits exhausted Duration Benefits expire

9. The theory implies that a rise in the benefit level • 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

10. Exit rate Effects of a rise in the benefit level Higher benefits Entitlement effect Benefits exhausted Duration

11. Strong empirical evidence on the impact of the potential duration of benefits: • Job finding increases as the worker gets closer to benefit expiration

12. Time limited UI and jobfinding in Sweden

13. 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

14. Optimal UI: Time limits • Seminal paper: Shavell and Weiss (1979) • a case for declining time profile • A wage tax as complement: Hopenhayn and Nicolini (1997): • 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

15. Endogenous work effort: Wang and Williamson(1996) • 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

16. 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 unemployment

17. Search equilibrium:Fredriksson and Holmlund (2001) • Endogenous search effort, wage bargaining • Two states of unemployment: • Insured (I) and Non-insured (N) • Stochastic benefit duration • Benefit entitlement through employment

18. Labor market flows

19. Value functions for Insured, Non-insured and Employed worker

20. 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 benefits • The welfare improvement relative to a uniform system is non-trivial

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

22. 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

23. 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

24. Value function for Insured worker,monitoring and sanctions FOC for optimal search, insured worker:

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

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

27. 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

28. 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 %

29. Other experimental evidence • Dolton, O’Neill (1996), UK • Risk of losing benefit if not showing up at interview • 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

30. 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 80-100 % • Lalive, van Ours, Zweimuller (2005) • Swiss evidence on the impact of warnings and actual benefit sanctions • Increase in the outflow from unemployment

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

32. Workfare and UI • Informal argument: active labor market policy as workfare • 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 doesn’t know individual preferences, only the distribution Kreiner and Tranaes (2005), Fredriksson and Holmlund (2006)

33. 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 leisure) • Makes it possible to raise benefits without making it worse for non-searching individuals

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

35. 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

36. 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?

37. Unemployment insurance savings accountsFeldstein-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 government • At retirement age: convert UISA into retirement income • The government cancels the debt if the balance is negative

38. 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

39. Conclusions • The case for penalizing less active search is solid • 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