Myopia, Fiscal Federalism, and Unemployment Insurance: Time to Reform UI Financing

Abstract

As commentators and Congress have recognized, the U.S. system of financing its unemployment insurance program is seriously dysfunctional. Extant reform proposals, however, do not fully diagnose the causes of current failures. In particular, other commentators neglect the role of fiscal myopia in state officials’ failures to save for future UI needs. For instance, reformers mostly propose offering rewards or penalties that will take effect only far in the future. These incentives have only small effects on myopic officials.

I show here with a simple model of time-inconsistent preferences that alternative mechanisms (detailed herein) that would offer immediate incentives would be considerably more cost-effective. This result also implies that the chance to forgive current state debts to the federal government represents an irreplaceable opportunity to leverage ex ante incentives; Congress should not forgive these debts without demanding significant state progress towards future stability.

Keywords: unemployment insurance, fiscal federalism, myopia, time-inconsistent preferences, rainy day fund, budget stabilization fund, state finance, taxation, behavioral public finance

JEL Classification: D72, D99, H53, H71, H77, J65