JOB MARKET PAPER

Optimal Unemployment Insurance Financing: Theory and Evidence from Two US States

Unemployment insurance provides crucial support for unemployed workers but comes with substantial costs. I study the optimal approach to financing unemployment benefits, comparing two alternative approaches to assign unemployment tax rates to employers. While employers in the United States are assigned individualized tax rates based on the unemployment benefit spending resulting from their layoffs (experience rating), in all other countries, all employers are assigned the same tax rate irrespective of their individual contributions to unemployment (coinsurance). I derive a formula that defines the optimal financing policy through a tradeoff between the marginal benefit and two marginal costs of coinsurance. The marginal benefit refers to the value of insurance for employers, as coinsurance protects them against the risk of steep tax increases and further financial deterioration following a negative shock. The first marginal cost is a moral hazard from reducing the private cost of layoffs for employers, which imposes a fiscal externality on government budgets in the form of more frequent layoffs and increased spending on benefits. The second marginal cost emerges from the subsidization of high-unemployment risk industries and the resulting reallocation of labor towards these industries. This results in the misallocation of productive skills and generates a further fiscal externality in the form of increased spending on benefits as more workers are subject to a high risk of unemployment. I express the formula for the optimal policy in terms of estimable sufficient statistics for welfare. I then use unemployment tax filing data from two US states and quasi-experimental variation in unemployment taxes from state-level reforms of experience rating policies to estimate the cost of labor reallocation. My results suggest that labor reallocation, an overlooked channel in the literature, is the primary source of inefficiency from coinsurance. Additionally, my finding that the combined marginal cost of moral hazard and labor reallocation exceeds the marginal benefit of coinsurance suggests that, in these states, the current degree of experience rating may be suboptimal.