It is well known that workers suffer when they lose their job and experience an unemployment spell – surveys indicate a sharp decrease in happiness, and average consumption falls by around 20% upon job displacement. And much research has studied how to efficiently insure workers against the risk of unemployment. Like any other insurance mechanism, unemployment insurance involves a trade-off between the gains from providing liquidity and insurance to unemployed workers and the cost of the implicit problem of moral hazard. Many authors have concluded that unemployment benefit replacement rates are close to optimal in the US (see for example Shimer and Werning 2007, Pavoni 2007, and Chetty 2008).
But wages, wealth, consumption, and unemployment duration tend to increase over the life cycle. Unemployed young workers also suffer large consumption losses upon unemployment, and respond little to changes in unemployment benefits. This suggests that workers’ incentive to search for a job varies over the life cycle, which raises the question whether workers of different ages should be insured differently against unemployment risk. In Michelacci and Ruffo (2014) we argue that, given present US labour market institutions, overall welfare would be improved if unemployment insurance were increased for relatively young workers (in their mid-twenties and early thirties) and decreased for older workers (in their forties and mid-fifties). The idea is that unemployment insurance is most valuable to young workers – because they typically have little means to smooth consumption during a spell of unemployment – while the costs of the implicit problem of moral hazard are minor – because young workers want jobs anyway to improve lifetime career prospects, and build up human capital whose marginal return is high when young.
The value of unemployment insurance across age groups
The intuition underlying this claim emerges by measuring the welfare gains of marginally increasing unemployment insurance expenditures for a specific age group of unemployed workers. The welfare gains are just a function of two simple statistics, which can be easily recovered from the data. They are increasing in the marginal utility of consumption of the unemployed workers in the age group, and decreasing in the elasticity of the age group’s unemployment to the corresponding unemployment benefits.1 Intuitively, the marginal utility of consumption of the unemployed gives the marginal value of the increase in unemployment insurance, while the elasticity of unemployment to benefits measures the incentive costs of moral hazard, which implies that more generous transfers drive up unemployment. Generally, a revenue-neutral change in unemployment insurance that raises benefits for one age group and lowers them for another age group is welfare improving whenever the welfare gains from unemployment insurance are larger for the former than for the latter group.
Using data from the Panel Study of Income Dynamics, the Current Population Survey, and from the Survey of Income and Program Participation, we conclude that in the US the welfare gains from unemployment insurance are unambiguously larger for younger than for older workers. Panel (a) in Figure 1 shows the age profile of the elasticity of unemployment to benefits, while panel (b) shows the profile of consumption of unemployed workers as a dashed line. Both profiles are increasing in age, which implies that the marginal utility of consumption is higher for younger workers than for older workers, while the unemployment elasticity is smaller. This means that providing additional insurance to young workers is highly valuable, while the incentive costs of moral hazard are small.
Figure 1. Elasticity of unemployment to benefits and consumption when unemployed
Large welfare gains from redistribution
To study the magnitude of the potential welfare gains of making unemployment insurance age-dependent, we have considered a conventional life-cycle model with decreasing returns to labour market experience and ongoing unemployment risk. The model is calibrated to match US labour market institutions and other key features of the workers’ life cycle. Panel (a) of Figure 2 plots the age profile of two measures of the welfare gains of marginally increasing unemployment insurance expenditures for a specific age group of unemployed workers.
Figure 2. The welfare gains of age-specific changes in unemployment insurance
The two measures are remarkably similar and generally decrease with age. Their value is close to 1.5 for workers in their twenties and close to 0.25 for those in their forties and early fifties. On the whole, this suggests that one unit of government money would yield six times more welfare gains when assigned to young unemployed workers than to middle-aged unemployed workers.
When we optimally choose age-dependent replacement rates to maximise the workers’ initial expected utility, we find that under the optimal age-dependent policy, replacement rates would rise from 50% as now to around 80% for workers in their mid-twenties, and 60% for those in their thirties (see panel (a) in Figure 3). Workers in their forties and fifties, instead, would get benefits of less than 10% of their last wage. The welfare gains of this hypothetical reform are equivalent to almost 1% of lifetime consumption, which is sizeable.
Figure 3. Optimal age-dependent unemployment insurance replacement rates
Note: Dotted lines correspond to the baseline economy, solid lines to the economy with optimal age-dependent income replacement rates from unemployment insurance.
Panel (b) in Figure 3 also shows as a solid line the age profile of the welfare gains of unemployment insurance after choosing optimally the age profile of unemployment insurance replacement rates. The age profile of the average marginal utility of consumption when unemployed is substantially flatter than in the baseline economy, while the elasticity of unemployment to benefits is generally smaller than in the baseline economy and tends to decrease with age. Because of this, the age profile of the welfare gains of unemployment insurance is now substantially flatter than in the baseline economy, whose profile corresponds to the dotted line in the figure.
A change in perspective
In our research so far we have focused only on the amount of unemployment benefits, but one could easily apply the same logic to study the welfare gains of also making other labour market institutions dependent on age. For example, the analysis could well be extended to study policies governing benefit duration, maximum benefit level, and eligibility, as well as employment protection, severance payments, and poverty assistance. Along some of these dimensions it could well turn out that older workers require more protection than younger workers. The same logic can also be easily extended to study the gains from redistributing benefits across workers of different gender or race. And more importantly this analysis should be extended to other countries, where the cost of unemployment and the incentive to search for new jobs could be very different from those faced by US workers. The key point is that governments and policymakers should take a life-cycle perspective in designing labour market institutions. After all, making government interventions conditional on observable, immutable indicators of skills and welfare (such as age, race, or gender) involves little distortions and could lead to large welfare gains.
Chetty, R (2008), “Moral hazard versus liquidity and optimal unemployment insurance”, Journal of Political Economy 116(2): 173–234.
Michelacci, C and H Ruffo (2014), “Optimal Life-Cycle Unemployment Insurance”, American Economic Review, forthcoming
Pavoni, N (2007), “On optimal unemployment compensation”, Journal of Monetary Economics 54(6): 1612–1630.
Shimer, R and I Werning (2007), “Reservation wages and unemployment insurance”, Quarterly Journal of Economics 122(3): 1145–1185.
1 One can easily develop this logic a little bit more formally. Consider a government that uses one dollar to finance an increase in unemployment benefits bn for a given age group n. Denote by µn the number of unemployed workers in the age group, by cun their consumption level when unemployed, and by U'(cun) their marginal utility of consumption. If all currently unemployed workers receive one unit of money, welfare would increase by µnU'(cun). But standard moral hazard problems imply that more generous transfers drive up unemployment, and each unemployed worker receives benefits bn. So a marginal increase in transfers yields only units of income to a currently unemployed worker, where is the elasticity of group n unemployment to the corresponding unemployment benefits. By multiplying the two terms we find the following welfare gains from the marginal change in government transfers: