In many search models of the labor market, unemployment insurance (UI) is conveniently interpreted as the value of leisure or home production and is, therefore, treated as a parameter. However, in reality, UI has to be funded through taxation that might be distortionary. In this paper, I analyze the welfare implications of different taxation systems within two equilibrium models of unemployment: random search and directed search. In a random search model without taxes, efficiency is typically not achieved, unless the so-called Hosios condition is satisfied. If the bargaining power of firms is large, a lump-sum tax can discourage firms from entering and improve welfare. In a directed search model without taxes, constrained efficiency is always achieved. Since firms direct workers to apply to them by posting wages, raising UI funds in a lump-sum manner always distorts the efficient allocation, as it gives firms an incentive to be excessively aggressive in their attempt to maximize the probability of filing up their vacancies. I discuss two ways through which this externality can be internalized and efficiency can be re-established.
directed search random search unemployment insurance optimal taxation