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

Chapter 14Unemployment Insurance, Disability Insurance, and Workers’ Compensation

Jonathan GruberPublic 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.


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.


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.


UI benefits are a function of previous earnings.

These benefits vary by state. Figure 1Figure 1 illustrates the unemployment

benefit schedule in Michigan.

Unemployment Benefits in Michigan

$0

$50

$100

$150

$200

$250

$300

$350

$400

$0 $50 $100 $150 $200 $250 $300 $350 $400 $450 $500 $550 $600 $650 $700 $750

Weekly Wage in Highest Quarter of Past Year

Wee

kly

Ben

efit

Figure 1

Benefits in Michigan initially rise, and are then capped at a maximum.


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.


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.


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.


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.


Table 1Table 1 shows the variation in WC across states for permanent and temporary injuries in 2003.

There is substantial variation across states in payment levels.

Table 1

Maximum Indemnity Benefits Paid to Selected Types of Work Injuries, 2003

Type of permanent impairmentState Arm Hand Index

fingerLeg 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

24,814 140,395 105,786 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

Workers’ compensation payments are quite for

permanent injuries.

Yet there are dramatic differences in generosity

across states.


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 2Table 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 Indefinite(with medical verification)

Difficulty of verification

Unemployment: easyJob 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 The duration of social insurance benefits around the worldbenefits around the world

One can compare the generosity of social insurance in the U.S. to other countries.

Figure 2Figure 2 contrasts the U.S. with several European countries. These countries tend to have higher replacement rates and longer periods of eligibility.

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Net Replacement Rates Over a Five-Year PeriodFor a One-Earner Couple With Two Children

0 4 8 12 16 20 24 28 32 36 40 44 48 52 56 60

40

60

80

100

20

Length of Unemployment (months)

Net

rep

lace

men

t ra

te (

%)

Sweden

Belgium

USA

Hungary

Spain

Figure 2

Other countries tend to have higher replacement

rates than the U.S.

Especially for extended spells of unemployment.

The duration of social insurance The duration of social insurance benefits around the worldbenefits around the world

The time pattern of benefits must balance the trade-off between three considerations: Consumption smoothing implies rising

benefits Work disincentives from moral hazard Targeting

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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¢.


INSURANCE PROGRAMS More generous UI crowds-out other

sources of income support: Households save less Spouses are less likely to work


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 3Figure 3 illustrates the evidence.

1 5 10 15 20 26

Weeks Out of Work

Exi

t R

ate

from

Une

mpl

oym

ent

0.165

0.035

0.050

0.100

Figure 3

The exits from unemployment are

fairly steady for most of the benefits period.

But towards the end of benefits eligibility,

the hazard rate spikes upward.


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 Moral hazard effects of Unemployment InsuranceUnemployment Insurance

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 4Figure 4.

Empirical

Empirical

EvidenEviden

cece

$700

Group L Group H

Before Increase

After Increase

High Quarter Earnings

Weekly Benefit Amount

$350

$50

$800

$400

Figure 4

Before the UI benefits increase, the maximum was $350, for those earning $700 or more.

After the UI benefits increase, the maximum was $400, for those earning $800 or more.

“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.”

Moral hazard effects of Moral hazard effects of Unemployment InsuranceUnemployment Insurance

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.

Empirical

Empirical

EvidenEviden

cece


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.


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.


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 5Figure 5.

1

2

3

4

5

6

7

8

9

1950 1960 1970 1980

% of men 45-54 not participating in labor force

Year

% of men 45-54 receiving disability insurance benefits

Percent

Figure 5

The two trends mirror each other

very closely.


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 ofKrueger’s study ofWorkers’ CompensationWorkers’ Compensation

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.

Empirical

Empirical

EvidenEviden

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Krueger’s study ofKrueger’s study ofWorkers’ CompensationWorkers’ Compensation

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.

Empirical

Empirical

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cece


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.


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 7Figure 7 shows the relationship between the UI tax rate and the benefit ratio.

The payroll tax is at first very steep, then

flattens out completely.

5.4

Figure 7

10% means that UI benefits equal 10% of a firm’s payroll over the past 4

years

The 45 degree line would be a fully

experience-rated schedule.

When the schedule is above the 45 degree line, firms pay more than employees get

out.

When the schedule is below the 45 degree line, firms pay less than employees get

out.

The benefit ratio is total UI benefits

divided by payroll.


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.


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” ofThe “cash cow” ofpartial experience ratingpartial experience rating

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%.

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The “cash cow” ofThe “cash cow” ofpartial experience ratingpartial experience rating

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!

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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 2Table 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 Indefinite(with medical verification)

Difficulty of verification

Unemployment: easyJob Search: nearly impossible

Some difficult Very difficult

Average after-tax replacement rate

46% 60% 89%

Variation across states


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

Documents

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