State dependence in labor market fluctuations: evidence, theory, and policy implications

This paper documents state dependence in labor market \ud uctuations. Using a Threshold\ud Vector-Autoregression model, we establish that the unemployment rate, the job separation\ud rate and the job finding rate exhibit a larger response to productivity shocks during periods\ud with low aggregate productivity. A Diamond-Mortensen-Pissarides model with endogenous\ud job separation and on-the-job search replicates these empirical regularities well. The transition\ud rates into and out of employment embed state dependence through the interaction of\ud reservation productivity levels and the distribution of match-specific idiosyncratic productivity.\ud State dependence implies that the effect of labor market reforms is different across\ud phases of the business cycle. A permanent removal of layoff taxes is welfare enhancing in\ud the long run, but it involves distinct short-run costs depending on the initial state of the\ud economy. The welfare gain of a tax removal implemented in a low-productivity state is 4.9\ud percent larger than the same reform enacted in a state with high aggregate productivity