Optimal Unemployment Insurance in Presence of Informal Sector

David Bardey, Universidad del Rosario
Abstract:

Using a two-period model, we investigate the consequences generated by the introduction of an UI program in an economy characterized by a dual labor market. More precisely, we adopt an optimal UI contract approach in a general equilibrium set-up (matching technology, wage bargaining in the formal sector, taxes to finance UI program) and we compare the different economic variables values (social welfare, GDP, size of informal sector, unemployment, etc...) taken in a situation of autarky and in presence of an optimal UI contract, in both cases assuming a steady state. We are able to identify different mechanisms at work and to point out the relevant parameters of the economy that crucially influence the results, especially concerning the size of the informal sector. According to the efficiency of the search technology, results obtained can be very different. When search efficiency is low, sub-employed workers prefer to devote more time in the informal sector. On the contrary, for higher value of the search efficiency technology, sub-employed workers have incentives to devote more time to secure a new formal job. In such a case, the unemployment increase is associated to a decrease of the size of the informal sector and an increase of the GDP in the economy. Finally, in line with papers dealing with moral hazard issue in optimal UI, our results confirm that the slope of the replacement rate must be decreasing over time. Moreover, higher is the productivity of the informal sector and stronger must be this slope. For values of this productivity superior to 50% of the formal sector productivity, it appears that UI programs that consist in giving all the benefits during the first period may be optimal.