Fiscal Externalities and Optimal Unemployment Insurance

Abstract

A common finding of the optimal unemployment insurance literature is that the optimal UI replacement rate is around 50%, implying that current levels in the US are close to optimal. However, a key assumption in the existing literature is that unemployment benefits are the only government spending activity. In this paper I show that recommendations for optimal UI levels are dramatically reduced when one incorporates the fact that UI spending is a small part of overall government spending. This occurs because the negative impact of UI on income tax revenues implies added welfare costs, a mechanism that I refer to as a fiscal externality. Using both a calibrated structural job search model and a "sufficient statistics" method that relies on reduced-form elasticities, I find that the optimal replacement rate drops to zero once fiscal externalities are incorporated. However, I also consider the possibility that more generous UI could increase reservation wages and thus potentially increase the tax base, and I show that this second fiscal externality could have important effects on the results, with an optimal replacement rate which could rise above 70%.

Liquidity Constraints, Fiscal Externalities and Optimal Tuition Subsidies

“…However, my results hold in a far more general analysis, as demonstrated in Lawson (2014), where I produce an expression that simplifies to exactly the same form. Additionally, to be conservative, I abstract away from non-monetary motivations for government support 8 See, for example, the constrasting conclusions of Heckman, Lochner, and Taber (1998a) and Lee (2005) on the impact of college enrollment on relative wages, the hypothesis of Acemoglu (1998) on directed skillbiased technological change, and the disagreement of Moretti (2004b) and Ciccone and Peri (2006) on the existence of spillovers.…”

“…Although this result is very general 15 -I demonstrate in Lawson (2014) that a formula of this sort could be applied to any government transfer program -this model has been conspicuous in its simplicity, for two reasons: ease of interpretation, and a starting point for the next step in my analysis, which is the replacement of the ratio of marginal utilities with some empirically observable quantity. Similar to the analysis of unemployment insurance in Chetty (2008), I will decompose the marginal utility term into two effects, which I call liquidity and substitution effects.…”

“…To make predictions out of sample, and thereby to produce an estimate of the optimal level of student grants, I need to make some functional form assumptions. In the current subsection, I make functional form assumptions about the sufficient statistics themselves; this approach is proposed in Chetty (2009), and has previously been used in sufficient statistic studies of unemployment insurance, including Baily (1978) and Lawson (2013). First, let me now denote the baseline values of quantities using hats, i.e.b = 2 andŜ = 0.388.…”

Are Sufficient Statistics Necessary? Nonparametric Measurement of Deadweight Loss from Unemployment Insurance

“…See Pei (2017) for an example of a planner objective function that does not impose a balanced budget. Lawson (2017) considers the existence of non-UI expenditures while also requiring budget balance, which leads to the same expression of the fiscal externality, but in implementing the formula, the tax rate required to fund the policy change is much larger.…”

“…More recent studies have sought to better understand the normative implications of these estimated behavioral effects for UI (e.g., Gruber 1997;Chetty 2008;Schmieder, von Wachter and Bender 2012;Lawson 2015Lawson , 2017Nekoei and Weber 2017;Kolsrud et al 2018). 1 The welfare analysis of UI by Chetty (2008), which builds on work by Baily (1978), specifies a stylized job search model in which a representative worker optimizes her search effort in response to UI benefits and a fixed-wage job offer distribution.…”