Abstract
A common finding of the optimal unemployment insurance literature is that the optimal replacement rate is around 50%; however, a key assumption is that UI is the only government spending activity. I show that optimal UI levels are dramatically reduced by the fact that UI is a small part of overall spending: the negative impact of UI on income tax revenues implies added welfare costs, a mechanism that I call a fiscal externality. Using both a calibrated structural job search model and a “sufficient statistics” method, I find that the optimal replacement rate is zero when fiscal externalities are incorporated.
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