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5Hopenhayn-Nicolini_JPE1997 - Optimal Unemployment...

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Optimal Unemployment Insurance Hugo A. Hopenhayn University of Rochester and Universitat Pompeu Fabra Juan Pablo Nicolini Universidad Torcuato di Tella and Universitat Pompeu Fabra This paper considers the design of an optimal unemployment in- surance system. The problem is modeled as a repeated principal- agent problem involving a risk-averse agent—the unemployed worker—and a risk-neutral principal, which cannot monitor the agent’s search effort. The optimal long-term contract subject to the associated incentive constraints is characterized. This contract involves a replacement ratio that decreases throughout the unem- ployment spell and a wage tax after reemployment that, under some mild regularity conditions, increases with the length of the unemployment spell. Some numerical results are presented that suggest that the gains from switching to this optimal unemploy- ment insurance scheme could be quite large. The performance of this optimal contract is also compared to alternative liquidity provision mechanisms. I. Introduction An important ingredient of social welfare policies in developed economies is the unemployment insurance program. For the Euro- We are grateful to Peter Diamond, Jonathan Gruber, and Jean-Jacques Laffont for many useful comments. We also wish to thank seminar participants at the Univer- sity of Chicago, University of Iowa, the Massachusetts Institute of Technology–Har- vard seminar in public finance, the Federal Reserve Bank of Minneapolis, and the National Bureau of Economic Research Summer Institute. We acknowledge John Knowles for his helpful suggestions in editing the paper. Hopenhayn gratefully ac- knowledges financial support from the National Science Foundation. [ Journal of Political Economy, 1997, vol. 105, no. 2] 1997 by The University of Chicago. All rights reserved. 0022-3808/97/0502-0002$01.50 412
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optimal unemployment insurance 413 pean Community countries, public expenditures on unemployment insurance averaged around 2 percent of gross national product for the second half of the 1980s, ranging from a low 0.23 percent for Luxembourg to a high 3.4 percent for the Netherlands (Melguizo and Lopez 1991). For Canada, Japan, and the United States, these numbers were 1.6 percent, 0.4 percent, and 0.4 percent, respectively, for the year 1990 (Green and Ridell 1993). In spite of their widespread use, unemployment insurance pro- grams have been widely criticized because of the perverse effects they have on the incentives for reemployment. In fact, many of the current programs have been designed with the aim of reducing these distortions. For instance, the benefit received may be a small fraction of the previous wage, and a certain number of previous pe- riods of employment may be required to qualify for benefits. In addi- tion, benefits usually expire after a relatively short number of pe- riods. The purpose of this paper is to examine more formally the problem of optimal design of an unemployment insurance program and to provide some estimates of the potential gains that could result from its adoption.
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