Welfare Effects of Short-Time Compensation

In addition to unemployment insurance (UI), many advanced economies operate short-time compensation (STC) schemes which partially compensate workers for a loss of income due to a reduction in hours. This paper studies the welfare effects of STC in a model in which firms experience idiosyncratic shocks to profitability and can respond by adjusting both employment and hours per worker. Firms have only limited access to external private insurance, hence government-provided insurance can be welfare-improving. When introduced into an economy with an existing UI scheme, STC can improve welfare through two channels. First, it may directly enhance the provision of insurance. Second, it can mitigate distortions of the composition of labor input caused by UI. Depending on whether technology at the firm level favors adjustment through layoffs or work sharing, the welfare effect through insurance can be negative. Even in this case the availability of STC can allow for improved insurance by counteracting UI distortions, thereby raising the optimal level of UI. Since higher optimal UI reduces employment, however, adopting the optimal combination of UI and STC does not necessarily increase employment.