Designing Effective Unemployment Insurance

This chapter reviews the critical economic factors determining the design of effective, publicly financed Unemployment Insurance (UI). UI provides replacement income to workers who lose their jobs. As private markets fail to effectively provide this insurance, mandatory public provision has become the norm across developed economies with considerable variation in the level and duration of the benefit payments. The Baily-Chetty sufficient statistic formulation has become the standard approach for evaluating these UI programs. The criterion is intuitive and flexible – the marginal benefit from UI payments should equal the marginal cost. The fundamental challenge is fully articulating and capturing these costs and benefits across different individuals, over the duration of unemployment, in a variety of labor markets conditions. Policy analysts need to evaluate the way in which a job loss impacts a worker’s consumption smoothing, job search during the unemployment spell, and saving decisions before the job loss. In addition, equity considerations complicate the determination of best UI practice. The impact of UI policy can differ in potentially contradictory ways over the short, medium, and long run. Potential spillovers and interactions occur through wage determination, in labor market performances, and with the social safety net. Best policy may vary over the business cycle. Unemployment is complicated, individuals can react in numerous ways to a job loss, and complementary labor market policies interact with UI provision. This chapter investigates these complications and a number of related issues associated with the causes and consequences of unemployment.