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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.

Suggested Citation

  • Raj Chetty, 2004. "Optimal Unemployment Insurance When Income Effects are Large," NBER Working Papers 10500, National Bureau of Economic Research, Inc.
  • Handle: RePEc:nbr:nberwo:10500
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    References listed on IDEAS

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    Citations

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    Cited by:

    1. Landais, Camille & Michaillat, Pascal & Saez, Emmanuel, 2010. "Optimal Unemployment Insurance over the Business Cycle," CEPR Discussion Papers 8132, C.E.P.R. Discussion Papers.
    2. 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;Forschungsinstitut zur Zukunft der Arbeit GmbH (IZA), vol. 2(1), pages 1-20, December.
    3. Raj Chetty, 2004. "Consumption Commitments, Unemployment Durations, and Local Risk Aversion," NBER Working Papers 10211, National Bureau of Economic Research, Inc.
    4. Yolanda F. Rebollo-Sanz & Nuria Rodriguez Planas, 2016. "When the Going Gets Tough... Financial Incentives, Duration of Unemployment and Job-Match Quality," Working Papers 16.11, Universidad Pablo de Olavide, Department of Economics.
    5. Martin Feldstein, 2005. "Rethinking Social Insurance," American Economic Review, American Economic Association, vol. 95(1), pages 1-24, March.
    6. Kroft, Kory, 2008. "Takeup, social multipliers and optimal social insurance," Journal of Public Economics, Elsevier, vol. 92(3-4), pages 722-737, April.

    More about this item

    JEL classification:

    • C41 - Mathematical and Quantitative Methods - - Econometric and Statistical Methods: Special Topics - - - Duration Analysis; Optimal Timing Strategies
    • D8 - Microeconomics - - Information, Knowledge, and Uncertainty

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