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Optimal Welfare-to-Work Programs Nicola Pavoni (University College - - PowerPoint PPT Presentation

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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

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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

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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

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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

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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

  • f 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

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SLIDE 5

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

  • f 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

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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

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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

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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 πh(h, e) > 0 ◮ no access to either storage nor borrowing

Pavoni-Violante, ”Optimal Welfare-to-Work Programs” – p. 6/13

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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

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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

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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

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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

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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

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SLIDE 14

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)

U s − U f ≥ e βπ(h) (IC) ◮ 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

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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

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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

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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

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Quantitative analysis

  • Calibration of the model to U.S. labor market
  • Compute optimal WTW program for the same level of expected

utility U0 promised by the current program ◮ Simulate current program to compute U0

Pavoni-Violante, ”Optimal Welfare-to-Work Programs” – p. 11/13

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Quantitative analysis

  • Calibration of the model to U.S. labor market
  • Compute optimal WTW program for the same level of expected

utility U0 promised by the current program ◮ Simulate current program to compute U0

  • 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

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Quantitative analysis

  • Calibration of the model to U.S. labor market
  • Compute optimal WTW program for the same level of expected

utility U0 promised by the current program ◮ Simulate current program to compute U0

  • 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

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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

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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

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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

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SLIDE 25

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

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SLIDE 26

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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10 20 30 40 50 60 0.2 0.4 0.6 0.8 1

Months Fraction of workers in each program Program assignment

10 20 30 40 50 60 0.2 0.3 0.4 0.5 0.6 0.7 0.8 0.9 1

Months Fraction of initial wage Payments (replacement ratio)

10 20 30 40 50 60 0.05 0.1 0.15 0.2 0.25 0.3 0.35

Months Fraction of current wage Subsidy upon re−employment

10 20 30 40 50 60 0.2 0.4 0.6 0.8 1

Months Fraction of workers in each program Program assignment

10 20 30 40 50 60 0.2 0.3 0.4 0.5 0.6 0.7 0.8 0.9 1

Months Fraction of initial wage Payments (replacement ratio)

10 20 30 40 50 60 0.05 0.1 0.15 0.2 0.25 0.3 0.35

Months Fraction of current wage Subsidy upon re−employment

SA UI JM Optimal Actual Optimal Actual SA UI JM Optimal Actual Optimal Actual

SKILLED WORKER UNSKILLED WORKER