Labor Market Policies During an Epidemic

The COVID-19 pandemic has resulted in a marked slowdown of economic activity and the loss of many jobs. We look at two major policy responses designed to counteract the consequences of containment measures—the introduction of payroll subsidies and the expansion of unemployment insurance (UI)—and study their implications for the labour market and economic welfare.

We develop a search model of the labour market and combine it with a standard epidemiological model. Our model features three key elements for understanding the current crisis. First, workers build firm-specific skills and know-how over time. Second, firms face financial constraints and cannot adjust wages easily. This leads to the destruction of firm-worker matches that would otherwise have remained viable. And third, the model allows for both temporary job separations (workers can be recalled) and permanent separations (workers need to find a new employer).

We find that when considered separately, payroll subsidies are preferred to an equivalent expansion of the UI program. This is because payroll subsidies preserve productive jobs in which workers have built specialized and firm-specific knowledge and skills over time. When considered jointly, however, an optimal policy mix allocates 20 percent of the government’s fiscal response budget to payroll subsidies and 80 percent to UI expansion. This partial expenditure on payroll subsidies is enough to preserve productive jobs, which enables a swift recovery after containment measures are lifted. Importantly, this leaves budget space for more generous UI payments. Increased UI generosity helps workers whose jobs payroll subsidies are unable to save to maintain a stable path of income and consumption.