Unemployment insurance and taxation: incentives vs. insurance

1. Unemployment insurance and taxation: incentives vs. insurance Torben M. Andersen University of Aarhus CEPR, CESifo and IZA

2. Unemployment insurance and labour market performance • Generous unemployment benefits: disincentive for job search + high reservation wage • Flexicurity debate: UI provides insurance which can be good for job search/reallocation

3. Welfare state perspective • Many welfare arrangements provide implicit insurance: direct welfare effect under risk aversion + eventual effect on risk taking • Financed by taxes: tax wedge affects incentives (but also provides some insurance)

4. GDP per capita Efficiency vs. Equity – different policy choices 40 IRE NOR USA 35 Efficiency DEN NLD 30 BEL JPN 25 SWE 20 15 55 60 65 70 75 80 Equity Trade-off: Efficiency and Equity Tax burden: 25% vs 50 % Economic efficiency 100-GINI Equity

5. Scandinavian puzzle • Why so high income, with so high taxes, generous social safety net??? • Off-sets • Active labour market policy • Child care • Implicit insurance

6. Incentives vs. insurance • How is the balance between the incentive and insurance effects of • Unemployment benefits • Income taxation

7. Model • Search model with a tax-financed unemployment insurance scheme + imperfect competition • Individuals choose search effort (e) • Unions determine wage (w) • Policy maker chooses benefits and taxes (b,τ)

8. Industry j: job openings • Job matches: • Employment: • Employment probability Stochastic variable Mean: E(θ) St.Dev: S(θ)

9. Real income metric: • U(y) , U’>0, U’’<0 • Expected utility can be written as the implicit utility function

10. Expected real income • Standard deviation • Incentive effects • Insurance effects

11. Individual effort • Maxe V(μ, σ) • Effect of taxes and benefits in general ambiguous:

12. Union • Standard monopoly union • Wage

13. Public sector • Benefits b to all unemployed • Proportional income tax: τ • Lump-sum tax: T • Budget constraint

14. μ σ Risk-Return – exogenous policies • Individual risk = aggregate inequality e

15. μ σ More risk (higher S(θ))

16. μ σ More elastic labour demand

17. Optimal effort level for given policies: Inefficiently low (tax distortion) • Distortion: increasing in τ,є and E(θ) decreasing in S(θ)

18. Policy choices • τ for given benefits b • b for given tax rate τ • τ and b with lump-sum taxation • τ and b without lump-sum taxation

19. μ σ Choosing the tax τfor given benefits b Higher tax High tax Low tax

20. Optimal tax τ >0 even though lump-sum taxation is available (provided b is not too high) • Insurance effect

21. μ σ Optimal policy: utilitarian policy maker Optimal policy: always a trade-off at the margin

22. μ μ σ σ Optimal benefits bfor given tax rate τ Low risk High risk

23. Policy implications • Insurance effects may counter incentive effects (up to some point) • Trade-off return-risk for individuals and the efficiency-equity for policy makers are not necessarily monotone – can be humpshaped • Optimal policies always imply a trade-off at the margin

25. μ σ

26. μ σ