A Context-robust Measure of the disincentive cost of Unemployment Insurance

In this paper we argue that the standard way of measuring the social cost from employment reductions in response to changes in unemployment insurance (UI) benefits using labor supply elasticities and marginal effects provides only a partial measure of the true disincentive effect and ensuing social costs of UI benefits. An important difficulty of the standard measures is that they are difficult to compare across different contexts, especially when the duration structure of unemployment differs substantially. For example in the case of UI extensions, the more individuals are at risk of exhausting benefits, the larger is the insurance-related transfer from UI and the higher is the effective incentive to respond to UI changes . Based on this insight, the paper proposes a straightforward alternative measure of the disincentive effect of UI: the ratio of the behavioral cost (BC) to the mechanical cost (MC) of a UI reform. The BC/MC ratio captures the labor supply distortion (similar to a deadweight loss) relative to the additional (mechanical) transfer induced by the UI reform. We show that this ratio captures the true social costs in the context of a canonical model of optimal UI as in Baily (1978) and Chetty (2008). We discuss how our alternative measure partly addresses the issue of shifting incentive structures as well. Another key advantage of the BC/MC ratio is that it can in principle be readily computed and compared across different types of UI reforms. We summarize the evidence regarding the BC/MC ratio for existing studies and find that it can have substantially different implications than traditional labor supply elasticities.