Carrots or Sticks? Short-Time Work vs. Layoff Taxes

<jats:p>While unemployment insurance systems are widely used to insure workers against income losses after separations, it is well known that they can inefficiently increase separations in the labor market. There are two distinct policy instruments commonly used by governments that can counter this known problem: layoff taxes and short-time work schemes. This study provides a search-and-matching model to evaluate which of the two is the better policy tool. We show that if only a few firms are financially constrained, layoff taxes are better because they do not distort working hours in the economy. With a large share of financially constrained firms, short-time work emerges as the superior tool, as layoff taxes cannot deter separations in financially constrained firms. Additionally, short-time work can help provide insurance against income losses to risk-averse workers that constrained firms cannot afford to provide in their wage contracts. Calibrating the model to the US economy, we find that short-time work is the superior policy instrument if at least 27.5 percent of firms in the economy are financially constrained. Finally, we show that combining both instruments can dominate either policy in isolation when sufficiently many firms of both types are present in the economy.</jats:p>