Optimal Use of Labour Market Policies

Labour market policies for the unemployed combine passive income
support with active measures that aim at improving jobseekers'
employment prospects. This paper extends the theoretical framework
developed by Pavoni and Violante (2005a) for the optimal choice between different active and passive policies. Their model is extended to a setting which allows for the use of a job search assistance programme that affects the exit rate to employment by raising search effectiveness, but not productivity in the job. These programmes are among the most widely used activation measures in OECD countries and should therefore be taken into account when considering the optimal design of labour market policies. The enriched model is used to answer a range of interesting policy questions. On the one hand, the optimality of the West German policy in the period 2000-2002 as well as the benefits from tightening monitoring are assessed. It is shown that sizeable budget savings could have been realised by switching to the optimal scheme, but that the net gains from tighter monitoring are only small. On the other hand, interesting results on the optimal use of job search assistance and training are derived. It is shown that existing policies already share some but not all features of the optimal scheme.