The empirical literature documents a substantial and rising amount of labor income risk, in particular, employment risk. In most countries, the government provides insurance against this type of risk through the payment of unemployment benefits. Other things being equal, the provision of unemployment insurance increases the welfare of risk-averse households. However, unemployment benefits also discourage unemployed households from exerting search effort thereby raising the overall unemployment rate. When employment drops, so does aggregate output. In designing the unemployment insurance system, governments therefore have to weigh the insurance benefits against the costs of distorted incentives. The latest major labor market reforms in Germany (Hartz Reforms) became effective in 2005 and 2006. The 2005-reform reduced the benefit payments for long-term unemployed households while the 2006-reform shortened the eligibility period for high benefit payments. Both reforms aimed at putting more weight on the incentive side of the unemployment benefit system. While the effect on the employment rate and production is unambiguously positive, it is due to the loss of insurance a priori not clear, how the new system is valued by the people. The valuation of these reforms, the so called welfare effect, is the ultimate performance measure of labor market reforms from the perspective of the society and can only be computed on the theory-based macroeconomic model. The purpose of this paper is to develop a tractable macroeconomic model, and to use a calibrated version of the model to evaluate the quantitative effects of the Hartz Reforms on unemployment, growth, and welfare. We find that first, the 2005-reform had ceteris paribus large employment effects: the equilibrium unemployment rate has been reduced by approximately 1.1 percentage points from 7.5 to 6.4 percent. Second, the drop in unemployment has led to substantial output gains. Third, employed and short-term unemployed households experienced a significant welfare gain, that is, the positive incentive effect dominates the negative insurance effect. However, the long-term unemployed have lost in welfare terms. Fourth, the effects of the 2006-reform are qualitatively similar, but quantitatively much smaller. Finally, a further decrease in the benefit rate leads only to small additional welfare gains.


Dynamic General Equilibrium, Heterogenous Agents, Human Capital, Labor Market Search, Unemployment Insurance, German Labor Market Reform