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Optimal Unemployment Insurance When Income Effects are Large

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  • Raj Chetty

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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Cited by:
  1. Pascal Michaillat & Emmanuel Saez & Camille Landais, 2011. "Optimal Unemployment Insurance over the Business Cycle," 2011 Meeting Papers 124, Society for Economic Dynamics.
  2. Martin Feldstein, 2005. "Rethinking Social Insurance," NBER Working Papers 11250, National Bureau of Economic Research, Inc.
  3. David Robalino & Michael Weber, 2013. "Designing and implementing unemployment benefit systems in middle and low income countries: beyond risk-pooling vs savings," IZA Journal of Labor Policy, Springer, Springer, vol. 2(1), pages 1-20, December.
  4. Raj Chetty, 2004. "Consumption Commitments, Unemployment Durations, and Local Risk Aversion," NBER Working Papers 10211, National Bureau of Economic Research, Inc.
  5. Kroft, Kory, 2008. "Takeup, social multipliers and optimal social insurance," Journal of Public Economics, Elsevier, Elsevier, vol. 92(3-4), pages 722-737, April.

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