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Optimal Unemployment Insurance When Income Effects are Large

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Author Info
Raj Chetty

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Abstract

Studies of the consumption-smoothing benefits of unemployment insurance (UI) have found that the optimal benefit level is very small, perhaps even 0, for conventional levels of risk aversion. In this paper, I derive a formula for the optimal benefit rate in terms of income and price elasticities of unemployment durations, directly inferring risk aversion for the unemployed from their behavioral responses to UI benefits. The optimal rate of social insurance is shown to depend positively on the size of the income elasticity and negatively on the size of the substitution elasticity. I estimate these elasticities using semi-parametric hazard models and variation in UI laws across states and over time. The estimates indicate that income effects account for 70% of the effect of UI on unemployment durations, and yield an optimal replacement rate around 50% of pre-unemployment wages. These results challenge the prevailing view that social safety nets provide minimal welfare gains at a large efficiency cost.

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Paper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number 10500.

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Date of creation: May 2004
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Handle: RePEc:nbr:nberwo:10500

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Find related papers by JEL classification:
C41 - Mathematical and Quantitative Methods - - Econometric and Statistical Methods: Special Topics - - - Duration Analysis
D8 - Microeconomics - - Information, Knowledge, and Uncertainty

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  26. Daron Acemoglu & Robert Shimer, 1999. "Efficient Unemployment Insurance," Journal of Political Economy, University of Chicago Press, vol. 107(5), pages 893-928, October. [Downloadable!] (restricted)
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  28. Atkinson, Anthony B & Micklewright, John, 1991. "Unemployment Compensation and Labor Market Transitions: A Critical Review," Journal of Economic Literature, American Economic Association, vol. 29(4), pages 1679-1727, December. [Downloadable!] (restricted)
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  31. Adam Szeidl & Raj Chetty, 2004. "Consumption Commitments and Asset Prices," 2004 Meeting Papers 354, Society for Economic Dynamics. [Downloadable!]
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  34. Raj Chetty, 2004. "Consumption Commitments, Unemployment Durations, and Local Risk Aversion," NBER Working Papers 10211, National Bureau of Economic Research, Inc. [Downloadable!] (restricted)
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Cited by:
(explanations, Please report citation or reference errors to , or , if you are the registered author of the cited work, log in to your RePEc Author Service profile, click on "citations" and make appropriate adjustments.)

  1. Raj Chetty, 2004. "Consumption Commitments, Unemployment Durations, and Local Risk Aversion," NBER Working Papers 10211, National Bureau of Economic Research, Inc. [Downloadable!] (restricted)
  2. Martin Feldstein, 2005. "Rethinking Social Insurance," American Economic Review, American Economic Association, vol. 95(1), pages 1-24, March. [Downloadable!]
    Other versions:
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