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Optimal Social Insurance and Rising Labor Market Risk

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  • Tom Krebs
  • Martin Scheffel

Abstract

This paper analyzes the optimal response of the social insurance system to a rise in labor market risk. To this end, we develop a tractable macroeconomic model with risk-free physical capital, risky human capital (labor market risk) and unobservable effort choice affecting the distribution of human capital shocks (moral hazard). We show that constrained optimal allocations are simple in the sense that they can be found by solving a static social planner problem. We further show that constrained optimal allocations are the equilibrium allocations of a market economy in which the government uses taxes and transfers that are linear in household wealth/income. We use the tractability result to show that an increase in labor market (human capital) risk increases social welfare if the government adjusts the tax-and-transfer system optimally. Finally, we provide a quantitative analysis of the secular rise in job displacement risk in the US and find that the welfare cost of not adjusting the social insurance system optimally can be substantial.

Suggested Citation

  • Tom Krebs & Martin Scheffel, 2019. "Optimal Social Insurance and Rising Labor Market Risk," Opportunity and Inclusive Growth Institute Working Papers 18, Federal Reserve Bank of Minneapolis.
    • Handle: RePEc:fip:fedmoi:0018
    DOI: 10.21034/iwp.18
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    References listed on IDEAS

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    1. Jacobson, Louis S & LaLonde, Robert J & Sullivan, Daniel G, 1993. "Earnings Losses of Displaced Workers," American Economic Review, American Economic Association, vol. 83(4), pages 685-709, September.
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    More about this item

    Keywords

    Labor market risk; Social insurance; Moral hazard;
    All these keywords.

    JEL classification:

    • E21 - Macroeconomics and Monetary Economics - - Consumption, Saving, Production, Employment, and Investment - - - Consumption; Saving; Wealth
    • H21 - Public Economics - - Taxation, Subsidies, and Revenue - - - Efficiency; Optimal Taxation
    • J24 - Labor and Demographic Economics - - Demand and Supply of Labor - - - Human Capital; Skills; Occupational Choice; Labor Productivity

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