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.