TY  - JOUR
AU  - Chetty,Raj
TI  - Optimal Unemployment Insurance When Income Effects are Large
JF  - National Bureau of Economic Research Working Paper Series
VL  - No. 10500
PY  - 2004
Y2  - May 2004
UR  - http://www.nber.org/papers/w10500
L1  - http://www.nber.org/papers/w10500.pdf
N1  - Author contact info:
Raj Chetty
Department of Economics
Harvard University
1805 Cambridge St.
Cambridge, MA 02138
Tel: 617-744-9492
E-Mail: chetty@fas.harvard.edu
AB  - Studies of the consumption-smoothing benefits of unemployment insurance (UI) have found that the optimal benefit level is very small, perhaps even 0, for conventional levels of risk aversion. In this paper, I derive a formula for the optimal benefit rate in terms of income and price elasticities of unemployment durations, directly inferring risk aversion for the unemployed from their behavioral responses to UI benefits. The optimal rate of social insurance is shown to depend positively on the size of the income elasticity and negatively on the size of the substitution elasticity. I estimate these elasticities using semi-parametric hazard models and variation in UI laws across states and over time. The estimates indicate that income effects account for 70% of the effect of UI on unemployment durations, and yield an optimal replacement rate around 50% of pre-unemployment wages. These results challenge the prevailing view that social safety nets provide minimal welfare gains at a large efficiency cost.
ER  -