Self-reported mental health has fallen sharply over the past decade. Previous research has shown that poor mental health is closely connected to indicators of labour market disengagement, such as job loss and skill mismatch. A growing share of unemployment benefit recipients suffer from health problems. And with over half of all benefit recipients receiving benefits for 2 years or more, it is critical that we better understand the role that mental health plays in long-term labour market disengagement.

In this micro note we explore the factors underpinning the strong negative association between mental health and unemployment benefit duration. Our research shows:

• The mental health of benefit recipients is strongly connected to optimism about finding work: raising an unemployed worker’s expectations about finding a job by 10% has roughly the same effect on mental health as giving a worker an additional $60,000 in annual income, on average.
• The correlation between mental health and unemployment benefit duration is explained by long-term benefit recipients having poorer mental health than short-term recipients (a `between worker’ effect). It is not because mental health deteriorates the longer someone receives benefits (a `within worker’ effect).

Our findings suggest that policies that improve the job finding expectations and mental wellbeing of Australian workers will help to reduce long-term labour market disengagement. But more research is needed to establish the causal links between mental health and labour market outcomes.