Optimal Welfare-to-Work Programs Nicola Pavoni (University College London, and IFS) Gianluca Violante (New York University, and CEPR) 2006 North American Summer Meeting of the Econometric Society Pavoni-Violante, ”Optimal Welfare-to-Work Programs” – p. 1/13
Introduction • Government expenditures on labor market policies across OECD countries amount to 3% of GDP: ◮ Examples of policies: unemployment insurance, social assistance, job-search monitoring, training, wage subsidies • Most governments use a mix of policy instruments Pavoni-Violante, ”Optimal Welfare-to-Work Programs” – p. 2/13
Introduction • Government expenditures on labor market policies across OECD countries amount to 3% of GDP: ◮ Examples of policies: unemployment insurance, social assistance, job-search monitoring, training, wage subsidies • Most governments use a mix of policy instruments • A Welfare-to-Work (WTW) program is a government expenditure program that combines different policies Pavoni-Violante, ”Optimal Welfare-to-Work Programs” – p. 2/13
What do we do? • We study WTW programs from a normative perspective • An optimal Welfare-to-Work (WTW) program is a program that maximizes the unemployed agent ex-ante utility, for a given level of government expenditures • We want to characterize: ◮ optimal sequence of policies ◮ optimal level and time-path of unemployment benefits ◮ optimal taxes/subsidies upon re-employment Pavoni-Violante, ”Optimal Welfare-to-Work Programs” – p. 3/13
What do we do? • We study WTW programs from a normative perspective • An optimal Welfare-to-Work (WTW) program is a program that maximizes the unemployed agent ex-ante utility, for a given level of government expenditures • We want to characterize: ◮ optimal sequence of policies ◮ optimal level and time-path of unemployment benefits ◮ optimal taxes/subsidies upon re-employment • The key trade-off to solve optimally is "insurance vs incentives" Pavoni-Violante, ”Optimal Welfare-to-Work Programs” – p. 3/13
How do we do it? • Dynamic principal-agent (government-worker) relationship with moral-hazard (unobservable worker effort), following Shavell and Weiss (1979), Hopenhayn and Nicolini (1997) • We generalize their set-up in two dimensions: 1. introduce human capital dynamics ◮ wages and unemployment hazard depend on human capital 2. develop a richer economic environment ◮ monitoring technology to observe worker’s search effort Pavoni-Violante, ”Optimal Welfare-to-Work Programs” – p. 4/13
Economic environment I • Agent’s intra-period utility u ( c ) − a ◮ Separable in consumption c and effort a ◮ u ( · ) increasing, concave, smooth, and u − 1 has convex first derivative (Newman, 1995) • Agent’s effort a ∈ { 0 , e } , i.e. two effort levels • Workers endowed with human capital h ≥ 0 , and the wage ω ( h ) is increasing in h Pavoni-Violante, ”Optimal Welfare-to-Work Programs” – p. 5/13
Economic environment II • Agent can be either employed or unemployed • Employment is an absorbing state • During unemployment: ◮ human capital depreciates: h ′ = (1 − δ ) h ◮ search with job-finding probability π ( h, a ) , where π ( h, e ) > π ( h, 0) = 0 , and π h ( h, e ) > 0 ◮ no access to either storage nor borrowing Pavoni-Violante, ”Optimal Welfare-to-Work Programs” – p. 6/13
Principal-Agent relationship • Agent’s search effort a is private information ◮ Monitoring technology: upon payment of per-period monitoring cost κ , principal can observe search effort a • The risk-neutral principal offers a contract that specifies: ◮ recommendations on the search effort level a ◮ consumption for agent ◮ use of search monitoring technology Pavoni-Violante, ”Optimal Welfare-to-Work Programs” – p. 7/13
Options of the contract as policies of the WTW program • Combination of recommendations on effort, and use of monitoring technology lead to 3 policy instruments: ◮ UI : Unemployment Insurance (high effort, no monitoring) ◮ JM : Job-search Monitoring (high effort, monitoring) ◮ SA : Social Assistance (low effort, no monitoring) Pavoni-Violante, ”Optimal Welfare-to-Work Programs” – p. 8/13
Options of the contract as policies of the WTW program • Combination of recommendations on effort, and use of monitoring technology lead to 3 policy instruments: ◮ UI : Unemployment Insurance (high effort, no monitoring) ◮ JM : Job-search Monitoring (high effort, monitoring) ◮ SA : Social Assistance (low effort, no monitoring) • Recursive representation with two state variables: ( U, h ) Pavoni-Violante, ”Optimal Welfare-to-Work Programs” – p. 8/13
Economic forces at work in the choice of policies • Returns to search (UI/JM vs SA): increasing in h Pavoni-Violante, ”Optimal Welfare-to-Work Programs” – p. 9/13
Economic forces at work in the choice of policies • Returns to search (UI/JM vs SA): increasing in h • Effort compensation cost (UI/JM vs SA): increasing in U Pavoni-Violante, ”Optimal Welfare-to-Work Programs” – p. 9/13
Economic forces at work in the choice of policies • Returns to search (UI/JM vs SA): increasing in h • Effort compensation cost (UI/JM vs SA): increasing in U • Incentive cost (UI vs JM) e U s − U f ≥ ( IC ) βπ ( h ) ◮ decreasing in h (for UI) ◮ increasing in U : if u − 1 has convex first derivative Pavoni-Violante, ”Optimal Welfare-to-Work Programs” – p. 9/13
Characterization • Proposition 1 : SA is an absorbing policy, i.e. if it is chosen at any period t, choosing it thereafter is optimal Pavoni-Violante, ”Optimal Welfare-to-Work Programs” – p. 10/13
Characterization • Proposition 1 : SA is an absorbing policy, i.e. if it is chosen at any period t, choosing it thereafter is optimal • Proposition 2 : Human capital depreciation is necessary for policy transition within an optimal WTW program, i.e. in absence of human capital depreciation, every policy is absorbing. Pavoni-Violante, ”Optimal Welfare-to-Work Programs” – p. 10/13
Characterization • Proposition 1 : SA is an absorbing policy, i.e. if it is chosen at any period t, choosing it thereafter is optimal • Proposition 2 : Human capital depreciation is necessary for policy transition within an optimal WTW program, i.e. in absence of human capital depreciation, every policy is absorbing. • Proposition 3 : With human capital depreciation, the optimal policy sequence of a WTW program is UI → JM → SA Pavoni-Violante, ”Optimal Welfare-to-Work Programs” – p. 10/13
Quantitative analysis • Calibration of the model to U.S. labor market • Compute optimal WTW program for the same level of expected utility U 0 promised by the current program ◮ Simulate current program to compute U 0 Pavoni-Violante, ”Optimal Welfare-to-Work Programs” – p. 11/13
Quantitative analysis • Calibration of the model to U.S. labor market • Compute optimal WTW program for the same level of expected utility U 0 promised by the current program ◮ Simulate current program to compute U 0 • Question I: How different are the features of the optimal program compared to the current one? Pavoni-Violante, ”Optimal Welfare-to-Work Programs” – p. 11/13
Quantitative analysis • Calibration of the model to U.S. labor market • Compute optimal WTW program for the same level of expected utility U 0 promised by the current program ◮ Simulate current program to compute U 0 • Question I: How different are the features of the optimal program compared to the current one? • Question II: How big is the budget saving for the government from adopting the optimal WTW program? Pavoni-Violante, ”Optimal Welfare-to-Work Programs” – p. 11/13
Calibration I: U.S. labor market • Period: one month • Focus on individuals aged 18-50, ≤ HS degree • Preferences: log( c ) − a • Skill depreciation rate: 15% per year • Unemployment hazard function π ( h ) estimated from monthly CPS Pavoni-Violante, ”Optimal Welfare-to-Work Programs” – p. 12/13
Calibration II: U.S. WTW system • Phase I: 6 months of UI, with 60% replacement ratio Pavoni-Violante, ”Optimal Welfare-to-Work Programs” – p. 13/13
Calibration II: U.S. WTW system • Phase I: 6 months of UI, with 60% replacement ratio • Phase II: Up to 24 months of Temporary Assistance for Needy Families ($740 per month) with enrollment into JM program: ◮ κ = $478 per worker-per month Pavoni-Violante, ”Optimal Welfare-to-Work Programs” – p. 13/13
Calibration II: U.S. WTW system • Phase I: 6 months of UI, with 60% replacement ratio • Phase II: Up to 24 months of Temporary Assistance for Needy Families ($740 per month) with enrollment into JM program: ◮ κ = $478 per worker-per month • Phase III: policies of social assistance (SA) ◮ Food Stamps , with indefinite duration ($290 per month) Pavoni-Violante, ”Optimal Welfare-to-Work Programs” – p. 13/13
Calibration II: U.S. WTW system • Phase I: 6 months of UI, with 60% replacement ratio • Phase II: Up to 24 months of Temporary Assistance for Needy Families ($740 per month) with enrollment into JM program: ◮ κ = $478 per worker-per month • Phase III: policies of social assistance (SA) ◮ Food Stamps , with indefinite duration ($290 per month) • Employment : Earned Income Tax Credit (wage subsidy program) and Federal and State Unemployment Tax Pavoni-Violante, ”Optimal Welfare-to-Work Programs” – p. 13/13
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