Experience Rating: Insurance Versus Efficiency

When unemployment insurance is publicly provided, firms' layoff decisions can be distorted. Unemployment insurance reduces the cost of laying off workers, thereby encouraging layoffs and leading to more unemployment. To dampen this increase in unemployment, it has been suggested that unemployment insurance should be financed with an experience rated tax. This paper examines the possibility that, despite that increasing the level of experience rating can reduce the level of unemployment, it can also reduce the wealth of unemployed workers. The reason for this is that, under high levels of experience rating, firms may reduce their severance payments by more than the publicly provided unemployment insurance benefit. We build a model where competitive firms offer long-term contracts to risk-adverse workers. Asymmetric information about workers' productivity leads to over-unemployment and incomplete private insurance against unemployment. This paper shows that an experience rated unemployment insurance program cannot increase the wealth of unemployed workers without increasing unemployment.