The Role of Workfare in Striking a Balance between Incentives and Insurance in the Labour Market



Unemployment insurance tends to distort incentives in the labour market, affecting job search and wage formation adversely. We show in a search-matching model that this moral hazard problem can be reduced by attaching a workfare requirement to the eligibility conditions for claiming unemployment benefits. Even when workfare has no effects on human capital or productivity, it is possible to improve labour market performance to create more jobs and lower unemployment by the introduction of workfare, and also to improve welfare. Hence the incentive structure in the labour market can be improved by workfare policies rather than benefit reductions.