How much unemployment insurance do we need?

Rafael Lalive, Camille Landais, Josef Zweimüller , 9 November 2013

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The global crisis that erupted in 2008 has put millions of workers out of a job. The US, for instance, experienced a dramatic increase in unemployment from around 4% to more than 10% during the Great Recession. Unemployment remained stubbornly high even when the economy began to recover.

Governments throughout the world have responded by making their unemployment insurance systems more generous (OECD 2012). Some observers argue that US unemployment would have returned much faster to normal levels if the US had not expanded the duration of benefit payments from 26 to 99 weeks. Were unemployment insurance extensions too generous? What is the optimal level of unemployment insurance? How much money should job seekers receive and for how long?

Optimal unemployment insurance

In theory, economists have a simple answer to these questions. Unemployment insurance should be set optimally, i.e. such that adding a dollar to unemployment insurance generosity produces as much benefit as it costs (Baily 1978). But how does one go about finding the right amount of unemployment insurance in practice? Actual policy needs to be based on sound evidence. Chetty (2008) discusses a new approach to finding the optimal amount of unemployment insurance. The key idea of his ‘sufficient statistics’ approach is to combine credible evidence on the benefits and costs of more generous insurance with a plausible theoretical framework to back out the optimal level of unemployment insurance.

But, what is the evidence regarding the costs and benefits of unemployment insurance extensions? The costs of more generous unemployment insurance are the total costs to taxpayers. The total costs have two components – direct and additional.

  • The direct costs are those paid to job seekers who exhaust their regular benefits.
  • Additional costs arise because more generous benefits induce job losers to stay longer on unemployment insurance benefits or enter unemployment more frequently.

Interestingly, a growing number of studies give us well-identified measures of the costs at the individual level. Card and Levine (2000) for instance find that adding 13 weeks of benefit payments will prolong job search by about one week in the US. Lalive and Zweimüller (2004) find a very similar impact for Austria. Lalive, van Ours, and Zweimüller (2006) discuss the costs of raising the benefit level compared to adding weeks of benefits, and find that increasing benefit levels is less costly than prolonging benefit duration.

Economists have spent less effort in estimating the benefits of unemployment insurance.

  • Unemployment insurance benefits individuals if it helps to better smooth consumption between employment and unemployment.

Gruber (1997) finds that job seekers experience a drop in consumption of 6% compared to when they were still employed. His estimates suggest that the drop in consumption would have been almost four times larger (22%) without unemployment insurance. This study therefore shows that unemployment insurance does what it is designed to do – insure people.

Unemployment insurance and search externalities

However, unemployment insurance generosity does not only affect individual workers’ search effort, it may also affect the competition for jobs. The idea is simple:

  • When generous unemployment insurance induces all other workers to search less intensively, it become easier for me to find a new job.

This means that optimal unemployment insurance needs to account for search externalities. Existing studies on the effects of extending unemployment benefits do not take these externalities into account. If these externalities are empirically relevant, then micro studies miss an important part of the picture.

Landais, Michaillat & Saez (2013) provide a theoretical analysis of optimal unemployment insurance in the presence of search externalities. They set up a search and matching model which shows that stronger search externalities increase the socially-desirable generosity of unemployment insurance. An important implication of this result is that unemployment insurance should be more generous during recessions – when jobs are scarce and externalities are strong. Conversely, unemployment insurance should be less generous during booms when jobs are plentiful and externalities are weak.

Empirical evidence for search externalities

Are search externalities really empirically relevant? Lalive, Landais and Zweimüller (2013) provide evidence for search externalities in a quasi-experimental setting. They study a programme that extended unemployment insurance benefits from one to four years for certain workers in certain regions of Austria during the period 1988–1993. They show that this massive benefit extension led to a substantial increase in unemployment duration among eligible job seekers (Figure 1A). It also led to a substantial reduction in unemployment duration among non-eligible job seekers (Figure 1B). This evidence indicates that the effects of benefit extension programmes on overall unemployment will be smaller than suggested by existing micro studies. Benefit-extension programmes reduce competition for jobs. Since the programme induces eligible job seekers to search less hard, non-eligible job seekers face lower competition and find jobs more easily.

Figure 1. Difference in unemployment durations between eligible and ineligible counties by year of entry into unemployment

Interestingly, recent studies conclude that the US benefit extension programmes of the Great Recession increased unemployment significantly, but by less than half a percentage point (Rothstein 2011, Farber and Valletta 2013). This evidence suggests that the unemployment insurance extensions in the US were less costly than previously thought.

References

OECD (2012), OECD Employment Outlook 2011, Paris.

Baily, Martin N (1978), “Some Aspects of Optimal Unemployment Insurance”, Journal of Public Economics 10(3): 379–402.

Card, David and Phillip Levine (2000), “Extended Benefits And The Duration Of UI Spells: Evidence From The New Jersey Extended Benefit Program”, Journal of Public Economics 78(1–2): 107–138.

Chetty, Raj (2008), “Moral Hazard versus Liquidity and Optimal Unemployment Insurance”, Journal of Political Economy 116(2): 173–234.

Farber, Henry and Robert Valletta (2013), “Do Extended Unemployment Benefits Lengthen Unemployment Spells? Evidence from Recent Cycles in the US Labor Market”, NBER Working Paper 19048.

Gruber, Jonathan (1997), “The Consumption Smoothing Benefits of Unemployment Insurance”, The American Economic Review 87(1): 192–206.

Lalive, Rafael and Josef Zweimüller (2004), “Benefit Entitlement and Unemployment Duration: The Role of Policy Endogeneity”, Journal of Public Economics 88(12): 2587–2616.

Lalive, Rafael, Jan van Ours, and Josef Zweimüller (2006), “How Changes in Financial Incentives Affect the Duration of Unemployment”, Review of Economic Studies 73(4): 1009–1038.

Lalive, Rafael, Camille Landais, and Josef Zweimüller (2013), “Market Externalities of Large Unemployment Extension Programs”, IZA Discussion Paper, forthcoming.

Landais, Camille, Pascal Michaillat, and Emmanuel Saez (2013), “Optimal Unemployment Insurance Over the Business Cycle”, NBER Working Paper 16526.

Rothstein, Jesse (2011), “Unemployment Insurance and Job Search in the Great Recession”, Brookings Papers on Economic Activity: 143–210.

Topics: Global crisis, Labour markets
Tags: search externalities, unemployment, Unemployment insurance

Professor of economics, University of Lausanne; Research Affiliate, CEPR

Camille Landais

Research Fellow, SIEPR, Stanford University

Professor at the Institute for Empirical Research in Economics, University of Zurich and CEPR Research Fellow