Optimal labor market policy with search frictions and risk-averse workers

•I characterize the optimal insurance policy in a search model of the labor market.•General equilibrium effects are key to the provision of insurance.•At the optimum, layoff taxes are typically higher than hiring subsidies.•Moral hazard does not change the results, unless workers have low bargaining power.

This paper characterizes the optimal policy within a dynamic search model of the labor market with risk-averse workers. In a first-best allocation of resources, unemployment benefits should provide perfect insurance against the unemployment risk, layoff taxes are necessary to induce employers to internalize the social cost of dismissing an employee but should not be too high in order to allow a desirable reallocation of workers from low to high productivity jobs, hiring subsidies are needed to partially offset the adverse impact of layoff taxes on job creation, and both unemployment benefits and hiring subsidies should be almost exclusively financed from layoff taxes. I obtain an optimal rate of unemployment which is, in general, different from the output maximizing rate of unemployment. When workers have some bargaining power, which prevents the provision of full insurance, it is optimal to reduce the rate of job creation below the output maximizing level in order to lower wages and increase the level of unemployment benefits. Thus, layoff taxes should typically exceed hiring subsidies which generates enough surplus to finance at least some of the unemployment benefits. The inclusion of moral hazard does not change this conclusion, unless workers have low bargaining power.