Unemployment Benefits and Redistributive Taxation in the Presence of Labor Quality Externalities

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In this paper, a worker's productivity is assumed to depend on his own quality and on the average quality of other employed workers. In this setting, unemployment benefits that induce low quality workers to leave the labor force have important efficiency as well as equity implications. In addition to unemployment benefits, the authorities can use a proportional income tax and lump sum transfers. The desirability of tax and transfer policy is considered from the perspectives of a utilitarian social planner and of an electorate consisting of employed and unemployed workers. Employed workers may be in favor of unemployment benefits, even though they do not benefit directly. If unemployment benefits are financed by lump sum taxes, then relatively high unemployment benefits may be favored by a coalition of the unemployed and of high quality employed workers.