Designing Unemployment Insurance Systems in Developing Countries: Moral Hazard vs Liquidity Constraints in Chile

One of the most complex social policy issues that developing countries commonly face is the question of how they can protect the unemployed. However, the analysis of unemployment insurance (UI) in developing economies with large informal sectors is in its infancy, with few papers providing solid empirical evidence. This paper makes several contributions to the development literature: first, it applies Chetty’s 2008 landmark work on UI to a developing country (Chile) and shows that the moral hazard effects expected by policy makers, who designed the system are minimal, while liquidity effects were entirely neglected. By means of an RDD, it analyses the Chilean UI system using a large sample of administrative data, which allows for an extremely precise analysis of how the system is working, thus providing invaluable empirical lessons for other developing countries.

Second, this paper shows that it is not enough merely to quantify an effect such as moral hazard, but to understand its causes and implications. An extended unemployment period stemming from moral hazard has extremely different welfare implications than one stemming from a liquidity effect and should therefore result in different policy recommendations.

Third, our results also highlight that the Chilean UI system is regressive overall, as it protects workers with higher income levels and more stable jobs much more than it protects vulnerable workers, who are also much more likely to become unemployed.

Fourth, this paper shows that it is essential that developing countries should take into account the specific labor market and macroeconomic context when designing social policies as the incentives embedded in such a policy may not be enough to compensate for the limitations that arise from the structure of a labor market.

This research thus has implications for many developing countries, which may also be considering the implementation of some form of UI and/or the partial or complete replacement of existing severance pay legislation with continuous contributions to individual savings accounts, as recommended by the international development institutions. Furthermore, even high-income developing countries, such as Chile, cannot rely on unemployment insurance alone when it comes to protecting workers from the fallout of an economic crisis or rapid changes in the labor market that generate unemployment. Any UI system must also be linked to other social protection mechanisms to provide complimentary benefits to workers with precarious jobs.