Notes on the Disincentive Effects of UI Benefits

By Rick McHugh, National Employment Law Project
(guest blogger)

A significant number of mainstream economists have joined with long-standing opponents of unemployment insurance (UI), all obsessing over the so-called "disincentive effects" of UI. Those raising concerns about disincentive effects of UI range from former Clinton Secretary of Labor Robert Reich to Heritage Foundation's Timothy Kane. A recent initiative from the Hamilton Project of the Brookings Institution brought further attention to this issue, in particular a paper by Jeffrey Kling. Faced with these criticisms, all focusing on disincentive effects of UI (and some promoting "rapid reemployment" as a priority solution for UI), it's worth looking at the disincentive effects issue more closely.

UI critics are unified in their concern about disincentive effects, but they present a range of solutions, including wage insurance, reemployment bonuses, and individual unemployment accounts. Most mainstream critics have proposed "wage insurance" as the best means to promote faster return to work by jobless workers. In essence, wage insurance provides a time-limited, partial wage subsidy to jobless workers accepting lower paying jobs in order to shorten the duration of UI benefit payments. In other words, wage insurance replaces part of wage losses experienced because the unemployed worker takes a lower paying job, rather than remaining on UI benefits and looking for a job paying wages closer to his or her former salary and benefits.

How Big Is the Impact of UI Benefits on Duration of Unemployment?

Economics assumes that paying UI benefits to jobless workers increases unemployment because UI benefits furnish an incentive for workers to remain unemployed longer than they would if they were out of work with no income support. This assumption is reasonable as far as it goes. In fact, disincentive effects are a deliberate feature of UI and not something that needs apologized for--UI benefits are designed to prevent the worst impacts of rapid loss of income due to job loss.

A key point in any discussion about disincentive effects should be that UI benefits in the U.S. are pretty low overall. In 2005, average weekly UI benefits in the U.S. were only $269 (or less than $1200 a month). This translates to $13,998 annually, or $1098 below the 2005 annual HHS poverty level for a two-person family. A March 2004 study of longer-term jobless workers by the Congressional Budget Office found that when UI recipients lost their jobs, household income—including UI benefits—dropped by about 40 percent. The CBO found that one-quarter of UI recipients who remained without work for four months or more fell into poverty despite the receipt of UI benefits. In other words, unemployed workers getting UI benefits are under intense financial pressure to return to work.

There are many studies that confirm the disincentive effect of UI on recipients, but the magnitude of the impact found in economists' simulations is far from uniform. In a 1997 summary of studies on the impact of receipt of UI benefits on duration of unemployment, Paul Decker wrote:

Although the exact magnitude of the response is uncertain, the lengthening in average unemployment spells is likely to be in the range of 0.5 weeks to 1.5 weeks for every 10 percentage-point increase in replacement rates.

Replacement rates refer to the portion of pre-layoff wages replaced by UI benefits. Note that Decker is speaking of a "10 percentage point increase," not a "10 percent increase." So, this generalization translates in current terms to a finding that if UI benefits were raised enough to increase replacement rates 10 percentage points, then the duration of unemployment last year would have been somewhere from 15.9 weeks to 16.9 weeks, instead of its observed duration of 15.4 weeks. Other studies have found that extending UI benefits by 13 weeks (as is commonly done during recessions) lengthens the duration of unemployment of recipients by roughly 2 weeks.

Some of UI's newer critics say their concerns about wage disincentive effects of UI arise because our labor market is producing more permanent layoffs and longer spells of joblessness than in the past. Now that more unemployed workers must find new jobs, rather than return to their prior employers, paying UI recipients makes less sense to these economists. While this observation about our labor markets is true enough, economists must be wrong if they believe wage disincentives of UI are explaining these labor market changes. That's because the generosity of UI benefits in terms of wage replacement hasn't really changed over recent decades. What's changed is the underlying labor market, which is producing greater economic insecurity in terms of longer-term unemployment and higher rates of permanent layoffs.

To sum up so far then, in terms of today's UI programs, we can say that poverty-level UI benefits in the U.S. undoubtedly have some impact on the length of unemployment for those getting benefits. Whether that impact is significant or modest, as Decker noted, seems to be in the eyes of the beholder. But, when viewed in the context of real world UI benefit levels and durations, the claim that the disincentive effects of UI benefits on recipients poses a major problem for UI programs (or our economy) is implausible, even if considered within the narrow terms of debate set by wage insurance proponents.

Impacts of UI on Workers Not Getting UI

A further point noted by several researchers is that most studies of duration focus on benefit recipients and do not consider impact of UI on non-recipients. Many critics focused on disincentive effects of UI likewise discuss only the impact of UI benefits on recipients. They don't take into account that the majority of unemployed workers (6 out of 10 in the U.S.) do not get UI benefits. Of course, these non-recipients are under even more economic pressure to look for and accept work than recipients. So, when the overall impact on both recipients and non-recipients of UI benefits is considered, the negative impact of UI benefits on unemployment is reduced.

Economists that have looked at the impact of UI have confirmed that UI affects both recipients and non-recipients. That is, the increase in weeks of unemployment on the part of UI recipients is offset to a greater or lesser degree by shorter unemployment spells on the part of non-recipients. These findings are consistent with the disincentive impacts of UI found for recipients, in the sense that if we assume that UI benefits lengthen unemployment durations for recipients, we should likewise assume that non-recipients have greater incentives to return to work more quickly. To paraphrase Decker's observation about this phenomena, when a group of unemployed individuals compete for a limited number of jobs, longer unemployment on the part of UI recipients should be roughly matched by shorter spells of unemployment on the part of non-recipients.

To date, economists have not studied these effects on non-recipients sufficiently to have a consensus on their impact, but their existence should be taken into account if the overall impact of UI on duration of unemployment is the economic problem we wish to solve. And, while their precise magnitude is not determined, the existence of these effects on non-recipients certainly means that the problem posed by UI's disincentive effects is smaller than some rhetoric directed at the UI program by its critics.

UI Has Positive Impacts on Overall Economy

Critics focusing on unemployment benefit durations also fail to fully acknowledge the positive impact of UI on the overall U.S. economy. A 1999 study by the prominent economist Lawrence Chimerine demonstrated that our UI program has moderated the impact of five post-World War II recessions. Chimerine's study found that over these five recessions (basically the five proceeding the 2001 recession), UI saved an average of 131,000 jobs in each downturn and reduced the drop in production (as measured by Gross Domestic Product) by 15 percent. Moreover, when jobless workers spent their UI benefits, the money created additional economic growth. Chimerine and his colleagues estimated that each one dollar of UI benefits led to $2.15 in increased domestic product. Surely, these sorts of positive economic impacts should be taken into account before we accept a judgment that our UI program's disincentive effects are a significant problem for the U.S. economy.

On a more microeconomic level, some economists have studied the question of whether permitting jobless workers a modestly more extensive job search has economic benefits. For example, if jobless workers find work that is more in line with their prior job experiences, skills, and aptitudes, this increases their productivity in their next job, not to mention that they might receive higher wages upon reemployment. Again, there has not been enough attention to these considerations by economists, but many fair-minded observers would at least concede that these positive economic impacts probably exist alongside the more generally acknowledged positive macroeconomic impacts of UI.

In short, a balanced consideration of the impact of UI programs requires more than a dismissive characterization of UI as a disincentive to employment. UI has a broader role to play in our economy, and its overall impact is positive, something you wouldn't know when reading some papers extolling wage insurance, reemployment bonuses, or individual accounts.

Is Wage Insurance Really the Best We Can Do?

Despite overall economic growth, most people in the U.S. remain concerned about the nation's economic future. A Labor Day 2006 poll by Pew Foundation found that "Americans believe that workers in this country are worse off now than a generation ago—toiling longer and harder for less in wages and benefits, for employers who aren't as loyal as they once were, in jobs that aren't as secure, and in a global economy that might very well send their work overseas." Wage insurance proposals fall far short of addressing the economic trends producing the anxieties reflected in this and other polls.

A big theme of the Bush Administration's Labor Department is "rapid reemployment." This idea is also advocated by some UI critics, including most proponents of wage insurance. A big reason for having wage insurance in the view of proponents is to get jobless workers to accept work more quickly by cushioning the impact when they accept worse jobs than they had prior to layoff. Rapid reemployment is assumed to be a good thing by its proponents, but this assumption needs closer examination. Encouraging rapid reemployment will have a direct impact on reducing UI payroll tax costs for employers, but it is much less clear that rapid reemployment will benefit jobless workers accepting worse jobs. And the impact on the overall economy is debatable. Before we get on the wage insurance train, we should at least consider that there is good evidence that better reemployment services and job search assistance would have an equivalent impact on duration of unemployment to that of wage insurance. And, providing more assistance to jobless workers might even cost less than wage insurance.

Is wage insurance really the best that mainstream economics can offer our nation's increasingly anxious middle class? In contrast to the timidity of wage insurance proponents, Jeff Madrick makes a broad claim for progressive policies in his book Why Economies Grow. Madrick called for a redefined social contract that will promote inclusiveness and adaptation to change by providing income protection, health care, and early childcare for all. Without this type of expanded social contract, Madrick argues that our economy will not grow as fast as it might, because income inequality, lack of child care and support for working parents, poor health care, and inadequate education impose costs on those that experience them--hidden costs that impede economic growth. Others have made similar arguments. Madrick's perspective challenges government, corporations, and other stakeholders to build a growing economy that supports middle class jobs where families have health care and can afford to send their kids to college.

In contrast, advocates of wage insurance are resigned to the fact that jobs paying adequate wages with health insurance and pensions are in decline. Wage insurance lets employers and government off the hook on key questions regarding job quality and economic growth in our global economy. Instead, wage insurance focuses its concern on the fact that some jobless workers resist accepting reduced living standards and lower-quality jobs by remaining on UI benefits for an extra week or two.

Rather than challenging the global economy's shortcomings, wage insurance's response is to pay a wage subsidy to promote rapid reemployment. Rather than changing the trade and government policies that underlie these troubling job quality developments, wage insurance provides an incentive to jobless workers to take worse jobs than they would otherwise accept. Surely, it's worth carefully examining whether this sort of incentive structure is the innovative policy its proponents claim, or simply an acceptance of the limitations imposed by mainstream economics and related public policies.

References

Chimerine, Lawrence, et al. "Unemployment Insurance as an Economic Stabilizer: Evidence of Effectiveness Over Three Decades," U.S. Department of Labor, UI Occasional Paper 99-8 (1999).

Congressional Budget Office. "Family Income of Unemployment Insurance Recipients: A CBO Paper." (March 2004)

Decker, Paul T. "Work Incentives and Disincentives" in Christopher J. O'Leary and Stephen A. Wandner, eds., Unemployment Insurance in the United States: Analysis of Policy Issues (1997).

Madrick, Jeff. Why Economies Grow: The Forces That Shape Prosperity and How We Can Get Them Working Again (2002).