Evaluating labor market reforms: A normative analysis

• What is the effect on welfare of a cut in unemployment benefits and firing costs?
• Welfare is reduced by lower firing costs, unlike for unemployment benefits.
• The result is driven by the wage channel.
• The spillover effect of this channel on welfare depends on the monetary dimension.
• Pre-announcement of reforms drives welfare effects to zero.

This paper shows that a reform aimed at improving labor market flexibility is not necessarily welfare-enhancing. We adopt a New-Keynesian model enriched with search and matching frictions. We investigate the effects of institutional labor market reforms, described by a permanent change in firing costs and unemployment benefits. Improving labor market flexibility by cutting unemployment benefits is welfare-enhancing for households. On the contrary, cutting firing costs reduces welfare. We argue that real wage dynamics play a crucial role in the results. Furthermore, welfare effects tend to zero when the reform is pre-announced.