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Saturday, March 13, 2010

What's the Optimal Level of Unemployment Benefits?

Given all the recent discussion implying that unemployment compensation increases job search time, and that is an unequivocal bad, I've been meaning to write about the benefits of unemployment compensation. That job search time goes up as a result of unemployment compensation is not necessarily bad if it leads to better matches between workers and employment. And there are other benefits of unemployment compensation as well, but Raj Chetty has this covered already in an interview from the January 2009 AEA meetings on Vox EU so I'll turn it over to him:

Public finance: theory, evidence and policy, Raj Chetty Interviewed by Romesh Vaitilingam, Vox EU: Romesh Vaitilingham: ...My name is Romesh Vaitilingham, and today's interview is with Professor Raj Chetty of Harvard University. Raj ... began by giving us an introduction to the issues that arise in his research.
Raj Chetty: So, I'm broadly interested in the role that the government should play in the economy, both on the side of tax policy – so, raising money to fund things like public goods and social welfare programs – and on the design of how we should be spending that money – so, how should we structure programs like unemployment insurance, various other social insurance programs, disability insurance, and so forth. ...
So, let me talk about a couple of specific examples. One set of topics relates to social insurance and optimal design. In particular, take an unemployment insurance program. So, a very simple question which is important for any economy is, what's the optimal level of unemployment benefits? This is something that we're hearing quite a bit about now, especially because of the recession, questions about whether we should extend unemployment benefits in the US, how high should we set the level of benefits and so forth.
So, there's a classic trade-off in this area, as with any social insurance program, which is, when you provide more insurance, you help people in a state of need. So, when they lose their jobs, they have less consumption, less income, and they're suffering, and you want to give them a transfer of that state. We think that that improves social welfare.
But, the cost of doing that is that you reduce incentives to find a job, right? So, if you provide too high an unemployment insurance benefit level, you might increase the unemployment rate and thereby end up sort of hurting people on net, even though you're providing them this transfer, by lowering GDP, in essence. So, a difficult question is, you want to be somewhere between a zero unemployment benefit and a full 100% replacement of your wages, but where do you want to be in the middle?
Now, traditionally, economists have had the view that you don't want to have a very high level of unemployment benefits because there's some pretty compelling evidence that when you raise unemployment benefits, people take longer to find a job, so unemployment durations go up. And that's a fairly powerful effect. A 10% increase in unemployment benefits, in various countries, has been estimated to raise unemployment durations by something like 5 to 8%, which is quite substantial.
And so, from that perspective, a view emerged that, because of this distortionary cost of the program, we don't want to have a very high level of unemployment benefits. And some calculations by MIT economist Jon Gruber suggested that the optimal benefit level may be very close to zero.
So, one aspect of reality that the standard model ignores that's used to make those calculations is the idea that people may not have sufficient liquidity while they're unemployed. So, a lot of calculations in economics are based on a traditional permanent income level, where people are smoothing consumption relative to lifetime income. But, when you're unemployed, that's precisely a time when you're unlikely to be able to smooth relative to permanent income because, if you think about what's necessary to be able to maintain a high level of consumption when you're unemployed, you have to be able to borrow, right? Or you have to have the high level of savings.
Now, it turns out that the median job loser in the US has savings of just $150, net of unsecured debt. So, they essentially have no savings at the time of job loss. Moreover, the primary condition for being able to borrow is having a job. So, it's exactly when you don't have a job or when you're sick that you can't borrow, right?
And so, now, if you consider a model where people are liquidity constrained, when they've lost their job, you get a second effect, a second reason why providing unemployment benefits might increase durations, which is what I call in this research I've been doing "the liquidity effect". And that's the idea that, if you have more cash on hand, you're not under as much pressure to rush and search and find a job, right? So, suppose you're really short on cash, you've had to drastically lower you level of consumption, and you're making a mortgage payment and you're behind your bills. You're going to do anything you can to just get a job as quickly as possible – sacrifice the quality of the job in order to put food on the table in the short run, right?
Now, if I give you unemployment benefits, you're going to have a little bit more time to find the job that you like, maybe search in a less costly way. And all that is not a distortionary incentive effect. It's not that you are thinking that the net return to work is lower than it actually is. It's just that you're able to take longer, do the more socially efficient thing.
Now, I go to the data, and I ask how much of the effect of unemployment benefits on durations is due to the liquidity effect, which is a socially beneficial thing, versus the moral hazard effect, which is the incentive distortion traditionally emphasized in the literature. And using various methods, basically comparing the effects of severance payments, which give you cash on hand but don't distort your incentives to the effects of increases in unemployment benefits, I conclude that roughly 60% of the effect of benefits on durations is a liquidity effect rather than a moral hazard effect. And using this type of evidence, I show that the optimal benefit level, viewed from this perspective, taking the liquidity consideration into account, is much closer to the level you see in the US – actually, 50% or something like that – and that it makes sense, probably, to extend the duration of employment benefits in a recession like this. Although you don't want to go too far, you don't want to go to a system like Sweden, which has sort of indefinite unemployment benefits. But, there's definitely significant value in having short-run liquidity provision when people face shocks.
So, more broadly, this research has similar implications for health insurance, disability insurance, workers' compensation – the same kind of effects are going to arise in all of those programs. And so there are various other research studies now following up on this that look for liquidity effects in these other programs and trying to think about how they should be decided.

So, that's one example of combining theory with evidence to reach a different policy conclusion. ...

Update: MIT's Ivan Werning is interviewed about his research with Robert Shimer on unemployment compensation:

Q. For how long should workers receive unemployment insurance benefits?
A. In most countries, unemployment insurance benefits can be collected for a limited amount of time — 6 months in the United States, although that is often extended during recessions, as it has been now. The conventional view is that limiting benefits prevents workers from gaming the system. While this idea seems appealing, in my research, I found that limiting benefits is not optimal.

When you think more about it, limiting benefits makes less sense. After all, those with the longest unemployment spells are those with largest losses from foregone earnings. In other insurance arrangements we see the reverse: In health or car insurance, you are not covered for the small expenses, but are fully covered for the larger ones. 

We should remain mindful of the incentive effects of unemployment insurance benefits and prevent anyone from manipulating the system. However, instead of limiting the duration of benefits, we need to get the level of benefits right.

Q. What determines the right level of benefits?
A. The level of unemployment insurance benefits must trade off the severity of the moral-hazard incentive effects [that is, the benefits must be low enough to motivate people to find new jobs] with the desire to help unemployed workers. Both sides of the equation depend on how well workers can cope with transitory losses of income while they are out of work. Typically, if workers have good access to liquidity, from their savings or access to credit, then optimal benefits should be relatively low. If instead, workers are liquidity-constrained, and consume primarily "hand to mouth" from current income, then benefits should be relatively higher. ...

Q. With some states now providing roughly 100 weeks of unemployment for some workers, are policy-makers beginning to change their thinking?
A. I'm not sure. Of course, there may be good reasons to vary insurance with the state of the economy. ... In the United States, during normal or boom times, relatively few workers remain unemployed long enough to actually exhaust their unemployment insurance benefits. In deep recessions, when more workers experience longer spells of unemployment, the duration of benefits is routinely extended. Going back to an earlier point, it makes sense to insure those with the largest losses, and it seems that the policies we actually implement in practice accept that [when governments extend benefits]. However, a better system could be designed by explicitly taking this point into account.

    Posted by on Saturday, March 13, 2010 at 10:35 AM in Economics, Social Insurance, Unemployment | Permalink  Comments (51)


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