Incentives versus insurance in the design of tax‐financed unemployment insurance

• Author: Torben M. Andersen
• Published date: 01 June 2016
• Date: 01 June 2016
• DOI: http://doi.org/10.1111/ijet.12085

doi: 10.1111/ijet.12085

Incentives versus insurance in the design of tax-financed

unemployment insurance

Torben M. Andersen∗

The distortions of job-search incentives caused by unemployment benefits and their financing

are well known. However, a benefit-tax scheme also provides insurance having direct utility

effects as well as indirect effects on risk taking. The latter mitigates or may even dominate

standard incentive effects to produce a non-monotone relation between efficiency (incentives)

and equity (insurance). An increase in benefits (and thus tax rate) may up to some point increase

average income and reduce inequality. However, optimal utilitarian policies always position the

economy at a point where marginal policy changes involvea trade-off, other wise policies would

not be optimal.

Key wor ds search, incentive, risk sharing, unemployment benefit

JEL classification D80, J20, J65

Accepted 2 March2015

1 Introduction

The role of unemployment insurance benefits for labor market performance is an important policy

issue due to the incentive effects arising from the direct role of benefits, but also due to the indirect

effect arising when benefits are financed by tax.1There is a vast literature analyzing these effects

of unemployment insurance both theoretically and empirically.2Many policy discussions of unem-

ployment benefits take these incentive effects as their starting point, and benefit generosity is often

mentioned as a reason for high unemployment rates.

However, the recent debate on flexicurity3has suggested that unemployment benefits via the

insurance they provide may actually have some effects conducive to labor market performance.

The argument being that flexible hiring/firing rules, in combination with generous unemployment

benefits, provide both flexibility to firms and security to workers. To the extent that agents are risk

∗Department of Economics and Business, Aarhus University, Aarhus, Denmark, CEPR, London, UK, CESifo, Munich,

Germany and IZA, Bonn, Germany.Email: tandersen@econ.au.dk

I gratefully acknowledge comments and suggestions by an anonymous referee and participants at presentations of earlier

versionsof this paper at St. Gallen, the SNS workshop, the ESOP workshop and the CESifo area conference on employment

and social policies.

1Moreover,unemployment benefits may affect the wage setting by, for example, imposing a lower bound on wages.

2For references and a critical discussion of the literature, see, for example, Howellet al. (2007).

3Much of the flexicurity debate is focused on the experience in Denmark with rather flexible hiring and firing rules

combined with a generous unemployment insurance scheme. See Andersen and Svarer (2007) for an account and

discussion of the Danish flexicurity model.

International Journal of Economic Theory 12 (2016) 127–150 © IAET 127

International Journal of Economic Theory

Tax-financed unemploymentinsurance Torben M. Andersen

averse, the insurance effect mayhave both a direct utility effect via risk pooling4and an indirect effect

by making job search activities less risky, which in turn may increase job search and contribute to

higher employment. Twoaspects of the flexicurity argument are particularly impor tant, namely that

there is a generous (mainly) tax-financed unemployment insurance scheme for all (universal) and

that flexible firing rules imply that there is a large turnover in the labor market. Since firms can easily

adjust their work force, a high incidence of short-term unemployment is to be expected, and a (short-

term) unemployment risk is present for most workers; that is, a large share of workersreceive benefits

for some part of the year.5The essence of the flexicurity debate is the balance between flexibility and

security, which in more general terms refers to the balance betweenincentives and insurance. This is

related to the point made in recent debates that cross-country evidence indicates that more equality

in the distribution of income is associated with higher income (see, for example, Wilkinson and

Pickett 2009; OECD 2011). This challenges the standard views on a trade-off between efficiency and

equity and seems to capture what in policy debates are often termed win–win situations.

The aim of this paper is to analyze the incentive and insurance effects of a tax-financed unem-

ployment scheme in a labor market with a high level of job turnover and thus risk of (short- or

long-term) unemployment. This paper does not address all aspects associated with the flexicurity

debate6but focuses on the security aspect; that is, the interplay between incentive and insurance

effects of the unemployment insurance scheme.

The present model is cast in such a way as to allow an explicit analytical solution admitting an

explicit characterization of the choice set in the efficiency–equity space open to policy-makers. This

is made possible by exploiting a somewhat neglected method utilizing a location–scale condition

allowing expected utility to be written as an indirect utility function specified over two moments (see

Meyer 1987; Sinn 1989). This allows more clear-cutanaly tical results on the roleof r isk aversionand

risk compared to standard approaches based on the direct utility function. Since the model has ex

ante risk and ex post differences in the position of individuals, it can be used to make inferences on

the relation between efficiency and equity facing policy-makers.

The approach makes it relatively straightforward to characterize the entire opportunity set avail-

able for policy-makers when determining policy instruments. While it is standard to proceed to a

characterization of the optimal policy under some social welfare function (usually utilitarian), the

entire opportunity set is seldom derived. It is shown that there may be a non-monotone relationship

between efficiency and equity; that is, up to some point an expansion of unemployment insurance

may improve both efficiency (employment/income) and equity (lower dispersion in consumption

possibilities); however, eventuallya t rade-off arises. It is worth stressing that this non-monotone re-

lationship is found under standard assumptions similar to those used in search models. The optimal

utilitarian policy is also considered and the optimal policy always has a trade-off between efficiency

and equity at the margin.

The model structure of the paper is purposely kept simple to capture the main mechanisms of

unemployment insurance and taxation for labor market performance and allow for analytical results.

Agents choose search effort which has a risky return due to unemployment risk driven by uncertain

length of employment spells (job tenure). Unemployment benefits are financed (in part or fully) by

4Which may also be important for ensuring political support for flexible hiring/firing rules.

5In Denmark, often highlighted as a “flexicurity” country, 28.9 percent of the unemployed in 2007 wereunemployed for

less than 1 month within the year, in contrast to only 8 percentfor OECD Europe. For a period of up to 3 months within

a year, the shareis 50.9 percent in Denmark and 25 percent in OECD Europe (www.sourceoecd.org).

6See also Lommerud and Straume (2008), Brown and Snower (2009) and Keuschniggand Davoine (2010) for analyses of

aspects of flexicurity.

128 International Journal of Economic Theory 12 (2016) 127–150 © IAET