Effect of Eligibility in Unemployment Benefits on Labor Market Behavior

Abstract

In the labor markets, there exist simultaneously both, unemployed workers and vacant jobs. Due to the market frictions matching these two is not that simple.

Matching models have been developed to depict the complexity of forming suitable matches in the labor markets. The government can affect the outcome in the labor markets through different policies. This paper focuses especially on unemployment compensation related policies, i.e. unemployment benefits. It is important to note that the unemployment benefits are used in the economy to promote better matches between workers and vacancies and smooth out consumption. However, they also create possibility for moral hazard; an unemployed worker might just enjoy the unemployment benefits without engaging in intense job search which results in higher unemployment rate. Thus the challenge faced by the government is to balance between the benefits of unemployment compensations and the disincentives they create.

In the basic matching model, the effect of unemployment benefits is very straight forward: They increase wages and decrease the labor market tightness thus increasing the unemployment rate. The basic model can still be developed further. This paper presents a model by Cahuc and Zylberberg (2004) that introduces eligibility criteria to the matching model. The idea is, that there are two types of unemployed: ones who are eligible to higher unemployment insurance payment and ones who are ineligible receiving lower compensation depending on the present governmental policy. In this model, raising unemployment benefits received by the eligible can even lower the universal unemployment rate.

This paper develops the idea of eligibility model by Cahuc and Zylberberg (2004) even further. Based on the idea of Pissarides (2000), the final model of the paper introduces four different policy parameters - marginal tax rate, tax subsidy and two replacement rates - through which the government can affect the equilibrium outcome, like the unemployment rate. The model suggests that the unemployment rate can be lowered by increasing marginal tax rate, making taxation less progressive or changing the relacement rates. However, making changes in these parameters can be rather controversial. This paper offers some policy recommendations for lowering the unemployment rate, but the results of the model should, however, be interpreted very carefully since economical models can always provide only a partial view on the big picture.