No. 2001-77 UNEMPLOYMENT VS. IN-WORK BENEFITS WITH SEARCH UNEMPLOYMENT AND OBSERVABLE ABILITIES

This paper explores the optimal interaction between the tax system and unemployment compensation in insuring people against the risks of involuntary unemployment and low ability. To that end, we introduce search unemployment in a model of optimal non-linear income taxation. We ...nd that the optimal search subsidy (i.e. the di¤erence between the in-work bene...t and the unemployment bene...t) increases if, for e¢cient agents, the participation constraint (governing job search) becomes relatively more important than the incentive compatibility constraint (determining hours worked). The relation between unemployment bene...ts and the optimal level of in-work bene...ts (the number of people exerting positive work e¤ort) is U (inversely U) shaped.