Jonathan Gruber Public Finance and Public Policy Chapter 14 Unemployment Insurance, Disability Insurance, and Workers’ Compensation Jonathan Gruber Public Finance and Public Policy Aaron S. Yelowitz - Copyright 2005 © Worth Publishers

Introduction Policy makers and the general public clearly care about social programs such as Unemployment Insurance (UI), Disability Insurance (DI), and Workers’ Compensation (WC). For example, there was an uproar in 2002 when temporary extended unemployment compensation was terminated, (it was quickly renewed).

Introduction Public finance economists ask why should the government intervene in these markets? The examination will come down to exploring the consumption smoothing benefits of these programs versus the inefficiencies created by moral hazard. In this lesson, we will explore these three major programs. They all are characterized by the fact that: They are triggered by an “adverse event.” Benefits are a function of previous earnings. Eligibility is often difficult to verify.

INSTITUTIONAL FEATURES OF UI, DI, AND WC: Features of Unemployment Insurance We will, in turn, explain some of the institutional features of UI, DI, and WC. Unemployment Insurance (UI) is a federally mandated, state-run program in which payroll taxes are used to pay benefits to workers laid off by companies for economic reasons. Although UI is federally-mandated, each state sets its own parameters on the program. This creates a great deal of variation across states, which many economists use as a “laboratory” for empirical work.

Institutional Features of Unemployment Insurance UI is financed through a payroll tax on employers. Thus, an employee will not see a deduction for UI on his or her paycheck. This payroll tax averages 2.5%. UI is partially experience-rated. The tax that finances the UI program rises as firms have more layoffs, but not on a one-for-one basis.

Institutional Features of Unemployment Insurance There are eligibility requirements for UI: First, individuals must have earned a minimum amount over the previous year. Second, the unemployment spell must be a result of a layoff, rather than from quitting or getting fired. Third, the individual must be actively seeking work and willing to accept a job comparable to the one lost.

Institutional Features of Unemployment Insurance These eligibility requirements mean that not all of the unemployed actually collect benefits. Only 44% of all unemployed collect UI. Even among eligibles, participation is not full. Roughly 66% of eligibles takeup the UI benefit. Non-participating eligibles result from lack of information about eligibility, stigma from collecting a government handout, or transaction costs.

Institutional Features of Unemployment Insurance UI benefits are a function of previous earnings. These benefits vary by state. Figure 1 illustrates the unemployment benefit schedule in Michigan.

Benefits in Michigan initially rise, and are then capped at a maximum. Figure 1 Benefits in Michigan initially rise, and are then capped at a maximum. Add 3 text boxes – one explain each segment of the schedule, and computing the replacement rate.

Institutional Features of Unemployment Insurance The replacement rate is the amount of previous earnings that is replaced by the UI system. Replacement rates vary from 35% to 55% of earnings, and UI is treated as taxable income.

Institutional Features of Unemployment Insurance In addition to benefits, the duration of UI can vary. In general, an individual can collect UI for 26 weeks. This varies: For those with sporadic work. For a state that has a “supplemental” UI program. If there is a federal extension, as in 2003.

Institutional Features of Disability Insurance Disability Insurance (DI) is a federal program in which a portion of the Social Security payroll tax is used to pay benefits to workers who have suffered a medical impairment that leaves them unable to work. Current expenditures are roughly $71 billion per year. Benefits are federally uniform, but the initial decision on qualification is made at the state level.

Institutional Features of Disability Insurance Unlike many other programs, there is a waiting period of 5 months before an individual can collect DI. The initial acceptance rate for DI is roughly 33%; after appeals to higher levels, the acceptance rate is roughly 50%. The benefits equal the primary insurance amount from Social Security, computed as if the applicant were age 65. The applicant qualifies for Medicare after two years on DI.

Institutional Features of Disability Insurance Detecting “true” disability is challenging. Parsons (1991) reported on a study in which a set of disability claims was initially reviewed by a state panel, and then one year later resubmitted as anonymous new claims. 22% of those who had initially qualified were rejected, and 22% of those initially rejected were qualified!

Institutional Features of Workers’ Compensation Workers’ Compensation (WC) is state-mandated insurance, which firms generally buy from private insurers, that pays for medical costs and lost wages associated with an on-the-job injury. The cash payment from WC is designed to replace two-thirds of workers’ wages. Unlike UI, these payments are untaxed, leading to a considerably higher replacement that can approach 90%. As with UI, there is substantial state variation in the program parameters. Unlike UI, however, the insurance premiums are more tightly experience rated.

Institutional Features of Workers’ Compensation Table 1 shows the variation in WC across states for permanent and temporary injuries in 2003. There is substantial variation across states in payment levels.

Type of permanent impairment Table 1 Maximum Indemnity Benefits Paid to Selected Types of Work Injuries, 2003 Type of permanent impairment State Arm Hand Index finger Leg Foot Temporary Injury (10 weeks) California $108,445 $64,056 $4,440 $118,795 $49,256 $6,020 Hawaii 180,960 141,520 26,800 167,040 118,900 5,800 Illinois 301,323 190,838 40,176 276,213 155,684 10,044 Indiana 86,500 62,500 10,400 74,500 50,500 5,880 Michigan 175,657 140,395 24,814 105,786 6,530 Missouri 78,908 59,521 15,305 70,405 52,719 6,493 New Jersey 154,440 92,365 8,500 147,420 78,200 6,380 New York 124,800 97,600 18,400 115,200 82,000 4,000 Yet there are dramatic differences in generosity across states. Workers’ compensation payments are quite for permanent injuries.

Institutional Features of Workers’ Compensation A key feature of WC is that it provides no-fault insurance. No-fault insurance–when there is a qualifying injury, the WC benefits paid out by the insurer regardless of whether the injury was the worker’s or the firm’s fault. In the early 20th century, workers could sue their employers, but the system was viewed as unfair because low-income workers may not have had the resources to bring suit against firms.

Comparison of the Features of UI, DI, and WC Table 2 summarizes the salient features of the three programs, emphasizing their similarities and differences.

Table 2 Comparing Unemployment Insurance, Disability Insurance, and Workers’ Compensation Characteristic UI DI WC Qualifying event Unemployment and job search Disability On-the-job injury Duration 26-65 weeks Indefinite (with medical verification) Difficulty of verification Unemployment: easy Job Search: nearly impossible Some difficult Very difficult Average after-tax replacement rate 46% 60% 89% Variation across states Benefits and other rules Only disability determination All three programs give benefits for fairly long durations. All three also have some difficulty in verifying the true “need” of recipients. Replacement rates vary substantially. Both UI and WC entail substantial variation across states.

The duration of social insurance benefits around the world Application One can compare the generosity of social insurance in the U.S. to other countries. Figure 2 contrasts the U.S. with several European countries. These countries tend to have higher replacement rates and longer periods of eligibility.

Net Replacement Rates Over a Five-Year Period Figure 2 Net Replacement Rates Over a Five-Year Period For a One-Earner Couple With Two Children 100 Sweden 80 Other countries tend to have higher replacement rates than the U.S. 60 Belgium Net replacement rate (%) Spain 40 Box: Typical European approach is to pay benefits for a fairly long period (a year or more) at a fairly high replacement rate. Box: When the time limit is reached, workers are moved to welfare system that usually features lower benefits for an indefinite period. Especially for extended spells of unemployment. Hungary 20 USA 4 8 12 16 20 24 28 32 36 40 44 48 52 56 60 Length of Unemployment (months)

The duration of social insurance benefits around the world Application The time pattern of benefits must balance the trade-off between three considerations: Consumption smoothing implies rising benefits Work disincentives from moral hazard Targeting

CONSUMPTION-SMOOTHING BENEFITS OF SOCIAL INSURANCE PROGRAMS There is comparatively little evidence on how much consumption smoothing exists for various social insurance programs. Recent empirical work finds for UI that: It mitigates the negative effects on consumption from unemployment. Every $1 of UI reduces the drop in consumption by 30¢.

CONSUMPTION-SMOOTHING BENEFITS OF SOCIAL INSURANCE PROGRAMS More generous UI crowds-out other sources of income support: Households save less Spouses are less likely to work

CONSUMPTION-SMOOTHING BENEFITS OF SOCIAL INSURANCE PROGRAMS There is no parallel evidence on consumption smoothing for Disability Insurance or Workers’ Compensation, however. DI should play a stronger consumption smoothing role than UI: disability is usually unexpected and permanent, so individuals are less able to use their own savings to smooth consumption. WC is less clear: if many claimed on-the-job injuries are really planned, then individuals may be well prepared to smooth their consumption.

MORAL HAZARD EFFECTS OF SOCIAL INSURANCE PROGRAMS There is a large body of literature concerning the moral hazard effects of UI, DI, and WC. Moral hazard distortions are the classic sort of “unintended consequences” that economists often talk about.

Moral Hazard Effects of Unemployment Insurance Moral hazard in UI is thought to manifest itself in the duration of the unemployment spell. Economists ask whether the unemployed exit unemployment more slowly when benefits are more generous. Figure 3 illustrates the evidence.

Exit Rate from Unemployment Figure 3 0.165 But towards the end of benefits eligibility, the hazard rate spikes upward. Exit Rate from Unemployment The exits from unemployment are fairly steady for most of the benefits period. 0.100 Box: Workers are much more likely to leave unemployment in the 26th week, the week that UI benefits end, than in any earlier week. Box: Exit rate jumps to 16.5% 0.050 0.035 1 5 10 15 20 26 Weeks Out of Work

Moral Hazard Effects of Unemployment Insurance In the 26th week of unemployment, precisely the time when benefits would run out, the exit rate from unemployment jumps up. Empirical work suggests a benefit elasticity of +0.8–each 10% rise in unemployment benefits leads to an 8% rise in unemployment durations.

Moral hazard effects of Unemployment Insurance Empirical Evidence The empirical approach, illustrated in Meyer (1989), makes use of cross-state and over-time variation for a “difference-in-difference” estimator. He also makes use of a persons position on the benefit schedule, for a “difference-in-difference-in difference” (“DDD”) estimator. This variation is shown in Figure 4.

Figure 4 After the UI benefits increase, the maximum was $400, for those earning $800 or more. Weekly Benefit Amount $400 After Increase $350 Before the UI benefits increase, the maximum was $350, for those earning $700 or more. Before Increase “Low earners” were unaffected by the policy change and form a “control group.” “High earners” were affected by the policy change and form the “treatment group.” $50 High Quarter Earnings $700 $800 Group L Group H

Moral hazard effects of Unemployment Insurance Empirical Evidence In this case, New Jersey increased its benefit schedule, while Pennsylvania did not. Only high earners in “Group H” were affected in New Jersey, however. Note that “Group L” in New Jersey was unaffected. A concern with the “difference-in-difference” estimator is that a recession may have hit New Jersey differently than Pennsylvania. Using “Group L” in both states accounts for this “recession effect” and forms the DDD estimator.

Moral Hazard Effects of Unemployment Insurance Is this moral hazard good or bad? If the unemployed individual is simply using the benefits to subsidize leisure consumption (e.g., watching television, etc.), then the increase in duration is inefficient. If the individual finds a better job match, society as a whole may gain. Job match quality is the marginal product associated with the match of a particular worker with a particular job.

Moral Hazard Effects of Unemployment Insurance The quality of job matches is difficult to observe; it is more straightforward to observe wages. Does more generous UI lead to higher wages for those leaving unemployment? No.

Moral Hazard in Disability Insurance Moral hazard in DI is thought to manifest itself in higher DI application rates and lower labor supply. If an applicant was “truly disabled,” then use of the DI program and work behavior should be unaffected by the benefit levels.

Moral Hazard in Disability Insurance DI was introduced in the 1950s, and the time series evidence seems to suggest the expansion in DI is highly correlated with withdrawal from the labor force among older men. See Figure 5.

The two trends mirror each other very closely. Figure 5 Percent 9 % of men 45-54 not participating in labor force 8 7 6 5 The two trends mirror each other very closely. 4 % of men 45-54 receiving disability insurance benefits Box 1: Highly correlated Box 2: OMV – WW2 veterans, private pensions 3 2 1 1950 1960 1970 1980 Year

Moral Hazard in Disability Insurance In addition, international evidence (where there is cross-sectional and over-time variation in DI generosity) suggests the implied elasticity of labor supply with respect to DI benefits is -0.3. In the U.S., applications for DI rise during recessions, even though it is unlikely that true disability changes. Applicants find it a less costly “gamble” to go through the process when their labor market opportunities are smaller.

Moral Hazard in Workers’ Compensation Moral hazard in WC is thought to manifest itself in reported injuries, injury durations, and types of injuries reported. Krueger (1990) finds that for every 10% in benefits generosity, the rate of reported injury rises by 7%.

Krueger’s study of Workers’ Compensation Empirical Evidence The evidence on injury duration is even more striking. Krueger (1991) finds that for every 10% in benefits generosity, the duration of injury rises by 17%. He uses a quasi-experiment from Minnesota in the 1980s. Minnesota had a WC program with three flat rates, and two sloped segments connecting these rates. On October 1, 1986 the state increased the benefits along the flat rate portion of the schedule only.

Krueger’s study of Workers’ Compensation Empirical Evidence The treatment groups are workers on the flat-rate portions of the schedule. The control groups are workers on the sloped part of the schedule. There were larger rises in injury duration for the treatment groups than the controls.

Moral Hazard in Workers’ Compensation Another piece of evidence for moral hazard comes from the types of injuries reported. True injury status is unobserved. Moral hazard will be worse for injuries that are hard to observe or verify, such as sprains or strains, and less of a problem for other types, such as lacerations or broken or missing limbs. Krueger (1991) found larger elasticities for difficult-to-verify injuries.

Moral Hazard in Workers’ Compensation Finally, there appears to be a “Monday effect” to WC claims. By examining claims by day of the week, there is a large rise in sprains and strains relative to lacerations on Mondays. This suggests some weekend injuries unrelated to the job are being passed on to the employer.

THE COSTS AND BENEFITS OF SOCIAL INSURANCE TO FIRMS In addition to the effects of the programs on workers, we can ask how the programs affect firm behavior. We will review: The incentive effects of partial experience rating in UI on layoffs The “benefits” of partial experience rating The “cash cow” of partial experience rating Issues that arise in the provision of workers’ compensation

The Effects of Partial Experience Rating in UI on Layoffs Partial experience rating means that a firm does not fully pay an additional tax each time it lays off a worker. Payroll taxes rise much less than one-for-one with layoffs. Figure 7 shows the relationship between the UI tax rate and the benefit ratio.

The benefit ratio is total UI benefits divided by payroll. When the schedule is below the 45 degree line, firms pay less than employees get out. Figure 7 When the schedule is above the 45 degree line, firms pay more than employees get out. 5.4 10% means that UI benefits equal 10% of a firm’s payroll over the past 4 years The benefit ratio is total UI benefits divided by payroll. The payroll tax is at first very steep, then flattens out completely. The 45 degree line would be a fully experience-rated schedule.

The Effects of Partial Experience Rating in UI on Layoffs Relative to a full system of experience rating, partial experience rating subsidizes firms with high layoff rates. How is this a “subsidy”? Firms and workers may make a joint decision whether to place the worker on temporary layoff, with a promise of being hired back later. UI system acts to make such behavior a partially paid vacation. With partial experience rating, the cost to the firm of doing this is less than the benefits to the workers.

The “Benefits” of Partial Experience Rating Why is partial experience rating so common in UI programs if it leads to more layoffs? The benefit that offset this moral hazard cost is consumption smoothing. Fully experience rated UI would “hit firms while they are down.” Yet, by having a partially experience rated system, it sustains inefficient firms that perhaps should be driven out of business.

The Effects of Partial Experience Rating in UI on Layoffs Empirical studies have examined state systems with different degrees of experience rating. They find that partial experience rating increases the rate of temporary layoffs. Partial experience rating alone can account for as much as one-third of all temporary layoffs in the U.S.

The “cash cow” of partial experience rating Application The situation in other countries creates even more moral hazard than in the U.S. In Canada, UI is financed through a flat payroll tax, unrelated to actual layoff behavior. In Canada, workers only have to work 10 weeks to qualify for 42 weeks of UI with a replacement rate of 60%.

The “cash cow” of partial experience rating Application Consider the consequences of such a system in Canada: You and four friends buy a fishing boat, and can catch $40,000 in fish during 50 weeks, or $8,000 per person. In the absence of UI, $8,000 is not enough for you or your friends to want to operate this business. With Canada’s UI system, you work for 10 weeks and are then “laid off.” Your earnings were $800 per week, of which 60% is replaced by UI for the remainder of the year. Your benefit from UI is 0.6*800*42, or $20,160. Across all 5 friends, $100,800. Adding the income from the actual work, each person gets $28,160 for only 10 weeks of work!

The “Benefits” of Partial Experience Rating This dramatically illustrates the problems with partial experience rating–it subsidizes the existence of inefficient firms. The structure of UI allows such a firm to remain viable.

Workers’ Compensation and Firms Similar issues arise in WC. If the system is not fully experience rated, firms and workers can get together to increase “injuries” and thus the payouts from insurance. Moreover, firms have less incentive to invest in safety, because the insurance is no-fault.

Workers’ Compensation and Firms Krueger (1991) examined injury durations at firms that self-insure and at firms that buy insurance in the partially experience rated market. By definition, self-insurance is full experience rating. The injury durations were shorter at these firms, and less sensitive to benefit increases.

IMPLICATIONS FOR PROGRAM REFORM There are several avenues for program reform: Benefits generosity Targeting Experience rating Worker self-insurance

Benefits Generosity Benefits generosity: The replacement rate should clearly be less than 100% because of moral hazard. Moral hazard is most pronounced for WC, large for UI, and smaller for DI. At the same time, the consumption smoothing benefits are likely largest for DI, and smaller for UI and WC. This evidence suggests benefits should be highest for DI, lowest for WC, with UI in the middle. Yet this is not the case, as summarized in Table 2.

Table 2 Comparing Unemployment Insurance, Disability Insurance, and Workers’ Compensation Characteristic UI DI WC Qualifying event Unemployment and job search Disability On-the-job injury Duration 26-65 weeks Indefinite (with medical verification) Difficulty of verification Unemployment: easy Job Search: nearly impossible Some difficult Very difficult Average after-tax replacement rate 46% 60% 89% Variation across states Benefits and other rules Only disability determination Replacement rates are highest for WC, even though moral hazard is large.

Targeting Targeting: There is evidence that the programs need to better target toward those who benefit the most from consumption smoothing, and/or for those for which the moral hazard problems are the smallest. Temporary layoffs & UI problematic Certain types of injuries & WC (and DI)

Experience Rating Experience rating: Relative to full experience rating, partial experience rating increases both layoffs and duration of workers’ compensation claims. The “consumption smoothing” motivations are weaker for businesses; inefficient businesses should be driven out in a capitalistic economy.

Worker Self-Insurance? Worker self-insurance: It is possible to replace the current system with “social insurance savings accounts” which could be used at retirement if there were positive balances. Worker self-insurance has many of the same advantages and disadvantages as privatized Social Security. Key advantage for UI and WC is the clear evidence of moral hazard and lack of consumption smoothing. Repayment if the balance goes negative is unclear, however.

Recap of UI, DI and WC Institutional features Consumption-smoothing benefits Moral hazard Costs and benefits to firms Program reforms