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

Compensation

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 Unemployment Insurance

Unemployment Insurance (UI) is a federally mandated, state-run program. Payroll taxes are used to pay benefits to workers laid off by companies for economic reasons. This payroll tax averages 2.5%.

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. 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 annual amount. 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 collect benefits (44% of unemployed collect). Even among eligibles, participation is not full.

Roughly 66% of eligibles take up the UI benefit. Non-participation (among eligibles) results from lack of information about eligibility, stigma from collecting a government handout, or from transaction costs.

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 unemployment benefit schedule in Michigan

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.

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, or if there is a federal extension, as in 2003. The time pattern of benefits must balance the trade-off

between three considerations: Consumption smoothing implies rising benefits Work disincentives from moral hazard Targeting

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.

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.

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 1

WC across states for permanent and temporary injuries in 2003

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 larger for

permanent injuries.

Yet there are dramatic differences in generosity

across states.

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.

Table 2

Comparing Unemployment Insurance, Disability Insurance, and Workers’

CompensationCharacteristic 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: 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

Benefits and other rules

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.

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

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¢.

There is no parallel evidence on consumption smoothing for Disability Insurance or Workers’ Compensation, however. DI and WC probably 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.

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.

Moral hazard in UI: are unemployment exits slower when UI benefits are higher?

Moral Hazard Effects of Unemployment Insurance

In the 26th week of unemployment, precisely the time when benefits 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.

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.

There is little evidence (using wages) that UI improves match quality.

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.

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%. He finds that for every 10% in benefits generosity, the duration of

injury rises by 17%. 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. He 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 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.

Partial experience rating in UI

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.

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.

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.

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 (at least for difficult-to-verify injuries), 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’

CompensationCharacteristic 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

Benefits and other rules

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.