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Unemployment Benefits or Taxes: How Should Policy Makers Redistribute Income over the Business Cycle?

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  • Ek Spector, Susanne

    ()
    (Confederation of Swedish Enterprise)

Abstract

This paper studies optimal unemployment benefit levels and optimal proportional income tax rates over the business cycle. Previous research suggests that policy makers should make unemployment insurance (UI) dependent on the business cycle because the UI system can be used to smooth consumption across different economic states. However, high benefits increase unemployment. An alternative way to redistribute income is to vary tax rates over the business cycle. In this paper, we develop an equilibrium search and matching model with risk-averse workers and two states, namely, a good and a bad state. The model yields potential ambiguity concerning the welfare effects of business cycle-dependent UI. The model is calibrated to United States (U.S.) labor market data. The numerical results suggest that higher benefits in the bad state are optimal, but the benefit differential is small. A more efficient way for policy makers to redistribute income over the business cycle is to decrease taxes in the bad state. Compared to an optimal uniform system, however, differentiation yields small welfare gains. Nevertheless, imposing two tax rates strictly dominates imposing two benefit levels. This finding is robust to a wide range of sensitivity checks.

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Bibliographic Info

Paper provided by Institute for the Study of Labor (IZA) in its series IZA Discussion Papers with number 6308.

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Length: 32 pages
Date of creation: Jan 2012
Date of revision:
Handle: RePEc:iza:izadps:dp6308

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Keywords: job search; business cycles; unemployment insurance; time-varying benefits and taxes;

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  1. Pierre Cahuc & André Zylberberg, 2004. "Labor Economics," MIT Press Books, The MIT Press, The MIT Press, edition 1, volume 1, number 026203316x, December.
  2. Camille Landais & Pascal Michaillat & Emmanuel Saez, 2010. "Optimal unemployment insurance over the business cycle," LSE Research Online Documents on Economics, London School of Economics and Political Science, LSE Library 35596, London School of Economics and Political Science, LSE Library.
  3. Kurt Mitman & Stanislav Rabinovich, 2011. "Pro-cyclical Unemployment Benefits? Optimal Policy in an Equilibrium Business Cycle Model," PIER Working Paper Archive 11-023, Penn Institute for Economic Research, Department of Economics, University of Pennsylvania.
  4. Michael Kiley, 2002. "How Should Unemployment Benefits Respond to the Business Cycle?," Computing in Economics and Finance 2002, Society for Computational Economics 167, Society for Computational Economics.
  5. Torben M. Andersen & Michael Svarer, 2011. "State Dependent Unemployment Benefits," Journal of Risk & Insurance, The American Risk and Insurance Association, The American Risk and Insurance Association, vol. 78(2), pages 325-344, 06.
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