Optimal Policy in a Labor Market with Adverse Selection

We study the optimal design of policies (such as unemployment insurance, taxation and minimum wage) in a frictional model of the labor market with adverse selection. Heterogeneous, risk-averse agents look for a job in a labor market characterized by an aggregate matching technology. Firms post vacancies but cannot observe each agent’s productivity. This paper emphasizes the need to take into account general equilibrium effects of labor market policies and focus on the non-observability of workers’ underlying skills as the main information friction. Our mechanism design approach shows that the constrained optimal allocation can be implemented by policy instruments such as a non-linear tax on wages, a non-constant unemployment insurance and firm subsidies. We calibrate our model to the US economy and characterize the welfare gains from the optimal policy and its effects on output, employment and the wage distribution. Our findings suggest that the optimal policy under a utilitarian government features a negative income tax, a more generous unemployment insurance for low-skilled workers and higher marginal tax rates, which results in a higher participation in the labor market and a lower unemployment rate. This paper also shows that a government with more egalitarian preferences would favor policies with more European characteristics: heavier taxation and more generous unemployment insurance, which result in a lower output and slightly higher unemployment rate.