Unemployment Benefits or Taxes:How Should Policy Makers Redistribute Incomeover the Business Cycle?

This paper studies optimal unemployment benefit levels and optimal proportional income taxrates over the business cycle. Previous research suggests that policy makers should makeunemployment insurance (UI) dependent on the business cycle because the UI system canbe used to smooth consumption across different economic states. However, high benefitsincrease unemployment. An alternative way to redistribute income is to vary tax rates overthe business cycle. In this paper, we develop an equilibrium search and matching model withrisk-averse workers and two states, namely, a good and a bad state. The model yieldspotential ambiguity concerning the welfare effects of business cycle-dependent UI. Themodel is calibrated to United States (U.S.) labor market data. The numerical results suggestthat higher benefits in the bad state are optimal, but the benefit differential is small. A moreefficient way for policy makers to redistribute income over the business cycle is to decreasetaxes in the bad state. Compared to an optimal uniform system, however, differentiationyields small welfare gains. Nevertheless, imposing two tax rates strictly dominates imposingtwo benefit levels. This finding is robust to a wide range of sensitivity checks....