Academic journal article Journal of Risk and Insurance

State Dependent Unemployment Benefits

Academic journal article Journal of Risk and Insurance

State Dependent Unemployment Benefits

Article excerpt


Optimal design of unemployment insurance is considered in a search setting where the state of nature (business cycle) affects the unemployment risk and thus the return to search. The incentive effects or distortions of individual job search arising due to the unemployment insurance scheme are crucial for optimal policies, so is the scope for risk diversification that depends critically on whether the balanced budget requirement applies to each state of nature or across states of nature. In the former case a basic budget effect tends to cause optimal benefits to be procyclical. If risk diversification across states of nature is possible, the fact that incentives are more distorted in good than bad states of nature tends to make both benefits and contribution rates countercyclical. It is shown that countercyclical benefits exacerbate employment fluctuations but increase average employment by aligning benefits more with states of nature where the incentive costs are small.


The design of unemployment insurance scheme is an important policy issue. Most of the recent empirical and theoretical literature has focused on the incentive effects of unemployment benefits, and many recent reforms have gone in the direction of tightening benefit systems (lower benefits, shorter duration, higher fees, etc.). However, these changes may impair the insurance properties of the schemes. An important question is whether a better balance between insurance and incentives can be attained by making benefits and their financing dependent on the state of nature (business cycle situation). Intuitively there is more need for benefits in a bad state of nature with a high unemployment risk at the same time as benefits are likely to be more distortionary in a good state of nature with good opportunities for job creation. These arguments both go in the direction of having countercyclical elements in unemployment insurance schemes, for example, more generosity in bad states of nature and vice versa.

Interestingly, some countries do have state of nature contingencies in the unemployment insurance scheme. In Canada, benefit levels, duration, and eligibility conditions are state of nature dependent, and in the United States, benefit duration is state of nature dependent. Many other countries have used semiautomatic adjustments of the unemployment insurance scheme, and even more have made discretionary changes depending on the state of nature.

There is a large literature on the design of unemployment insurance schemes. Since Bailey (1978), it is well known that the optimal benefit level trades off insurance and incentives. Recent work has extended these insights in various directions (for a survey see, e.g., Frederiksson and Holmlund, 2004). Surprisingly, there is neither a large theoretical literature on the design of state dependent unemployment insurance nor an empirical literature exploring the state dependencies in the effects of various labor market policies including the benefit level. Kiley (2003) and Sanchez (2008) argue within a search framework that the initial benefit level should be higher and its negative duration dependence weaker in a business cycle downturn compared to an upturn. Both models are partial in the sense that budget effects are disregarded and they both rely on the assumption that benefits are more distortionary in a boom.

The following develops a simple static search model to clarify the interaction between insurance and incentives in the determination of optimal unemployment benefits financed by an income tax. The model is cast in such a way as to yield insights on how the benefit level depends on the overall employment level (unemployment risk). The financing of the benefit scheme turns out to be very important, and in particular the ability to diversify risk not only between employed and unemployed but also across states of nature. We therefore consider, in turn, the cases where the budget balances for each state of nature and across states of nature. …

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