On the Provision of Insurance Against Search-Induced Wage Fluctuations

August 29, 2014

By Jean-Baptiste Michau


This paper investigates the provision of insurance to workers against search-induced wage fluctuations. I rely on numerical simulations of a model of on-the-job search and precautionary savings. The model is calibrated to low skilled workers in the U.S.. The extent of insurance is determined by the degree of progressivity of a non-linear transfer schedule. The fundamental trade-off is that a more generous provision of insurance reduces incentives to search for better paying jobs, which is detrimental to the production efficiency of the economy. I show that progressivity raises the search intensity of unemployed worker, which reduces the equilibrium rate of unemployment, but lowers the search intensity of employed job seekers, which results in a lower output level. I also solve numerically for the optimal non-linear transfer schedule. The optimal policy is to provide almost no insurance up to a monthly income level of $1450, such as to preserve incentives to move up the wage ladder, and full insurance above $1650. This policy halves the standard deviation of labor incomes, increases output by 2.4% and generates a consumption-equivalent welfare gain of 1.3%. Forbidding private savings does not fundamentally change the shape of the optimal transfer function, but tilts the optimal policy towards more insurance at the expense of production efficiency.

There is no doubt this paper will generate controversy, but it makes sense. Suppose that workers do not like fluctuations in their wages as they move from job to job. Clearly, they would like to obtain insurance against such fluctuations. But if they get it, a moral hazard problem arises whereby they would not search hard enough for a new job if their current one has low pay before insurance. Such an economy would have a poor allocation of resources, as output could be higher with better job matches. The solution appears to be that low-wage jobs should not be insured at all, to preserve incentives for search.

People will object that this provides no insurance to the most vulnerable. We need to define vulnerable here. The common definition would be low-skilled workers who can only obtain low wage jobs. This is not what this paper is about. People who lost out in the life-lottery because they were born with fewer skills or in an environment that is less conducive to accumulate skills should obtain a different type of insurance, likely through social welfare. What this paper is about is how typically young workers bounce around from job to job until they find the right match. You want to provide them some insurance while giving the right incentives to search. And sometimes this involves not giving insurance.

Two papers on taxing the top x%

August 26, 2014

Heterogeneity and Government Revenues: Higher Taxes at the Top?

By Nezih Guner, Martin Lopez-Daneri and Gustavo Ventura


We evaluate the effectiveness of a more progressive tax scheme in raising government revenues. We develop a life-cycle economy with heterogeneity and endogenous labor supply. Households face a progressive income tax schedule, mimicking the Federal Income tax, and flat-rate taxes that capture payroll, state and local taxes and the corporate income tax. We parameterize this model to reproduce aggregate and cross-sectional observations for the U.S. economy, including the shares of labor income for top earners. We find that a tilt of the Federal income tax schedule towards high earners leads to small increases in revenues which are maximized at an effective marginal tax rate of about 36.9% for the richest 5% of households – in contrast to a 21.7% marginal rate in the benchmark economy. Maximized revenue from Federal income taxes is only 8.4% higher than it is in the benchmark economy, while revenues from all sources increase only by about 1.6%. The room for higher revenues from more progressive taxes is even lower when average taxes are higher to start with. We conclude that these policy recommendations are misguided if the aim is to exclusively raise government revenue.

Taxing top earners: a human capital perspective

By Alejandro Badel and Mark Huggett


We assess the consequences of substantially increasing the marginal tax rate on U.S. top earners using a human capital model. The top of the model Laffer curve occurs at a 53 percent top tax rate. Tax revenues and the tax rate at the top of the Laffer curve are smaller compared to an otherwise similar model that ignores the possibility of skill change in response to a tax reform. We also show that if one applies the methods used by Diamond and Saez (2011) to provide quantitative guidance for setting the tax rate on top earners to model data then the resulting tax rate exceeds the tax rate at the top of the model Laffer curve

By coincidence, two papers on a very similar topic were listed in the same NEP-DGE report. And they have rather different results: Top tax rates of 37% versus 53%. How come? The models are quite different in fact. While the first one experiments with a tilting of the tax schedule, the second only increases the tax rate only of the top earners. This can justify part of the difference. Then the second one includes a human capital accumulation effect, which should actually lead to a lower top taxation rate. But as it considers the top 1% earners, while the first paper takes the top 5%, the results are not really comparable. Still both papers demonstrate that the top rates are lower than what simpler models show, and the additional complexity matters.

This all reminds us that quantitative results can sometimes be sensitive to 1) what your are measuring, and 2) what effects to include in the model. Hence the importance of either comparing results with previous literature as long as the models are nested or providing simplified models within the paper to gauge the impact of additional features.

An Estimated DSGE Model with a Deflation Steady State

August 13, 2014

By Yasuo Hirose


Benhabib, Schmitt-Grohé, and Uribe (2001) argue for the existence of a deflation steady state when the zero lower bound on the nominal interest rate is considered in a Taylor-type monetary policy rule. This paper estimates a medium-scale DSGE model with a deflation steady state for the Japanese economy during the period from 1999 to 2013, when the Bank of Japan conducted a zero interest rate policy and the inflation rate was almost always negative. Although the model exhibits equilibrium indeterminacy around the deflation steady state, a set of specific equilibria is selected by Bayesian methods. According to the estimated model, shocks to households’ preferences, investment adjustment costs, and external demand do not necessarily have an inflationary effect, in contrast to a standard model with a targeted-inflation steady state. An economy in the deflation equilibrium could experience unexpected volatility because of sunspot fluctuations, but it turns out that the effect of sunspot shocks on Japan’s business cycles is marginal and that macroeconomic stability during the period was a result of good luck.

DSGE models had to break new ground with the zero lower bound on interest rates because of the inherent non-linearities. This is even more the case when the models are estimated. Here, the problem is even deeper, as Japan has had a long period of deflation, and the canonical model predicts indeterminacy. This paper shows that you can still estimate such a model, thanks to good old Bayes.

Optimal Policy with Informal Sector and Endogenous Savings

August 8, 2014

By Luz Adriana Flórez


This paper analyzes the effect of social security and lump sum layoff payment in an economy with an informal sector and savings, where the search effort is unobserved. I characterize the optimal consumption/search/non-participant strategy assuming that workers are risk averse and that formal jobs last forever. After including job destruction shocks I solve the model numerically, and focus on the effects of lump sum layoff and social security payments on workers’ decision to be formal, informal or non-participant. I find that severance payments protect formal workers against the unemployment risk. With severance payments workers do not over-accumulate to protect themselves against unemployment, instead they increase the search effort through the re-entitlement effects. In this respect my work resembles that of Coles (2006). I find that in the steady state a high severance payment increases the proportion of formal workers while reduces the proportion of informal workers and those who decide not to participate in the labor market. Even though the optimal policy with severance payment is generous, I find that in the steady state the unemployment rate is low and welfare improves.

In countries where the inromal sector is large, it is a challenge to run various services that rely on universal participation, such as unemployment insurance. There, finding ways to give the right incentives for joining the formal sector is important. This paper provides a nice discussion of this.

Childcare Subsidies and Household Labor Supply

August 7, 2014

By Nezih Guner, Remzi Kaygusuz and Gustavo Ventura


What would be the aggregate effects of adopting a more generous and universal childcare subsidy program in the U.S.? We answer this question in a life-cycle equilibrium model with joint labor-supply decisions of married households along extensive and intensive margins, heterogeneity in terms of the presence of children across households and skill losses of females associated to non-participation. We find that subsidies have substantial effects on female labor supply, which are largest at the bottom of the skill distribution. Fully subsidized childcare available to all households leads to long-run increases in the participation of married females and total hours worked by about 10.1% and 1.0%, respectively. There are large differences across households in welfare gains, as a small number of households – poorer households with children – gain significantly while others lose. Welfare gains of newborn households amount to 1.9%. Our findings are robust to differences among households in fertility and childcare expenditures.

There are plenty of empirical studies addressing the same question, but the big problem is that so many measures are endogenous (general equilibrium!), including factor prices that are important for labor supply decisions. This is why studies like this one are very important, as they highlight the channels through which public policies have an impact. What this paper shows is that matters are almost impossible for the empiricist: either there is a natural experiment with a small segment of the population, where the wages are not affected and the results thus miss something very important, or it is a nationwide experiment where wages are affected but they can also be affected by many other things.