Unemployment benefits for heterogeneous workers: The Danish welfare state in a turbulent environment

Abstract

This thesis examines unemployment benefits in a framework with heterogeneous agents in a model calibrated for the Danish economy. Initially the analysis utilizes the general equilibrium search model developed by Ljungqvist and Sargent (1998), who use it to explain an increase in unemployment in Europe, through the introduction of economic turbulence in terms of skill shocks. This model is extended by introducing a two-tier benefit system, mimicking the one currently observed in Denmark with limited benefit durations and re-entitlement periods. The results show that these policies diminish the effect of the turbulence, which in turn indicates that the conclusions from the original paper are not robust, and the model is deemed unfit to explain the observed empirical data. Furthermore the results point to a less generous welfare state being superior to that of the current one, even though the continuous implementation of limited durations has improved the efficiency of the state significantly. This is mainly due to disincentive effects observed for the highly skilled part of the population, which can be lowered significantly with a lower replacement rate. These results are however ambiguous, due to the exclusion of active labor market policies in the model, which could have the potential to legitimize a higher replacement rate. Finally the aspect of heterogeneous workers is analyzed in the extended model, where it is found that this dynamic introduces important incentives, through the risk of losing skills and the potential for accumulating skills. These effects still appear to be dominant when introducing the two-tier system, and the skill mechanism is a powerful tool when modeling worker incentives and income differences.