Killing Them with Kindness: Negative Distributional Externalities of Increasing UI Benefits

Of the many labour market Hartz IV reforms that have been implemented in Germany since 2005, the role of short-term unemployment insurance has not received much attention. In this paper we examine distributional effects of la- bour earnings and unemployment benefits using simulated increases in unem- ployment insurance replacement rates or equivalently, increases in the net present value of benefit duration. Starting around an 18%-point increase in the replacement rate, there are significant negative labour supply effects, drawing those employed into unemployment shifting the mass of the earnings distribution to the left. At around a 25%-point increase in the replacement rate, the mass of the distribution shifts right again, as those receiving unem- ployment benefits simply enjoy an increased transfer. Thus, due to the sub- stantial negative labour supply effects, German economic policy should avoid potentially increasing the UI benefit replacement rate (or equivalently, in- creasing the benefit duration) in the near future as a response to the world- wide economic crisis.