Optimal Policy in a Dynamic Search Model with Risk Aversion

This paper characterizes the optimal labor market policy within a dynamic search model of the labor market which allows for workers’ risk aversion. In a …rst-best allocation of resources, unemployment bene…ts should provide perfect insurance against the unemployment risk, layo¤ taxes are necessary to induce employers to internalize the cost of dismissing an employee but should not be too high in order to allow a desirable reallocation of workers from low to high productivity jobs, hiring subsidies are needed to partially o¤set the adverse impact of layo¤ taxes on job creation and payroll taxes should be approximately equal to zero. I derive an optimal rate of unemployment and show that it is lower when the unemployment risk is partly non-insurable. Importantly, the optimal level of layo¤ taxes and hiring subsidies is independent of the amount of public good expenditures, even when payroll taxes are distortionary. When workers have some bargaining power, it is optimal to reduce the rate of job creation below the output maximizing level in order to lower wages which enhances the provision of insurance. Thus, layo¤ taxes should typically exceed hiring subsidies which generates enough surpluses to …nance at least some of the unemployment bene…ts. Keywords: Unemployment insurance, Layo¤ taxes, Hiring subsidies, Optimal rate of unemployment JEL Classi…cation: D60, E62, H21, J38, J65 I am grateful to Pierre Cahuc, Pierre Chaigneau, Barbara Petrongolo, Steve Pischke, Christopher Pissarides, Jean Tirole and to seminar participants at the LSE for useful comments and suggestions. Contact: [email protected]