Unemployment insurance and precautionary saving

Models of precautionary saving imply that households will hold more assets when faced with greater income uncertainty. However, previous empirical studies of income uncertainty have produced somewhat mixed support for the precautionary saving hypothesis. In this paper, we note that differences in the state-contingent income stream available to workers through the unemployment insurance (UI) program provides an excellent source of variation for testing the presence of a precautionary savings motive. Simulations of a stochastic life cycle model suggest that a UI system similar to the type currently in place in the U.S. can lead to a significant reduction in the assets accumulated by a median worker. Moreover, there is considerable variation in the UI benefit schedules for workers living in different states in the U.S., which provides an exogenous source of variation for empirically testing the precautionary saving hypothesis. We carry out this test using data on expected UI benefit replacement rates and financial assets held by households in the Survey of Income and Program Participation. Our empirical results are consistent with the predictions of the model and suggest that reducing the UI benefit replacement rate by 50 percent would increase gross financial asset holdings by 14 percent, or $241, for the average worker. We also find empirical evidence that this "crowd out" effect of UI on household saving is stronger for those facing higher unemployment risk and weaker for older workers, both of which are implications from our precautionary saving model. (C) 2001 Elsevier Science B.V. All rights reserved.