Unemployment Insurance in a Free Society

Policy Reports | Welfare

No. 274
Tuesday, March 29, 2005
by William B. Conerly, Ph.D.

Executive Summary

Unemployment insurance was intended to provide a financial safety net for laid-off workers. But the way the system is structured encourages employers to lay off employees and discourages workers from seeking new jobs until their benefits are nearly exhausted. The system is in many respects unfair — for example, part-time workers and those who change jobs frequently are taxed, but often are ineligible for benefits. And those who never make a claim receive no benefit in exchange for the taxes they pay. It is also wasteful and inefficient. In some states nearly 20 percent of benefit payments are the result of error or fraud. In general, state administrators have no incentive to reduce fraudulent claims or operate their programs efficiently.

The system actually encourages layoffs by shielding employers and workers from the true cost of such layoffs, causing as much as 50 percent of temporary layoffs in the depths of a recession. The reason: the tax rate an employer pays is not fully adjusted for the cost the employer imposes on the system through layoffs. Thus employers with high layoff rates are subsidized by others. In a free labor market, employers offering seasonal employment would have to pay higher wages in order to compete against employers who offer year-round employment. Unemployment benefits undercut this natural market phenomenon and act as a subsidy to employers whose need for labor is cyclical or seasonal.

The system also encourages people to remain unemployed once they lose a job by discouraging job search activities until benefits are almost exhausted. Because benefits for low-wage workers replace 50 percent or more of their previous pay, the loss of benefits upon reemployment acts as a 50 percent tax, in addition to all other taxes. This acts as a powerful disincentive to find a new job. There is abundant evidence that people respond to the economic incentives benefits provide:

  • Workers eligible for unemployment insurance benefits remain unemployed longer than those who are ineligible.
  • Workers offered bonuses for rapid reemployment find work faster than those who are not, and the new wages are slightly better than their former pay.
  • The probability of an unemployed person finding a job rises dramatically the week before the end of the person’s eligibility for unemployment insurance.

Fortunately, there is a better way. The simplest solution is the most comprehensive one: replacing unemployment insurance with personal employment accounts that are individually owned, totally portable and benefit workers even if they are never involuntarily unemployed. A portion of the payroll taxes paid would be put into investment accounts that workers own and control. People could withdraw funds from their accounts during periods of unemployment, and any unused funds would add to their retirement incomes.

Chile, which led the world in establishing individual accounts for social security, has implemented such a personal account system. The accounts are funded by payroll taxes. Workers own their accounts, but prior to retirement they only withdraw funds when they are unemployed. The accounts are administered by the same private funds that manage Chilean workers’ retirement accounts, and are invested conservatively in a variety of securities. Unlike the U.S. unemployment system, Chileans can draw the funds out even if they quit or were fired from their last jobs. This allows workers more flexibility in changing employment.

If the United States implemented a personal unemployment account system, both workers and employers would have incentives to minimize unemployment. Unlike the use-it-or-lose it benefits of the current system, workers would not forgo benefits when they find a job quickly. After all, any unused funds in their accounts would be their own money. Also, employers would have incentives to provide steady, year-round employment since seasonal work would not be artificially subsidized.

Short of a comprehensive solution, states should be given more flexibility to experiment with a variety of reforms. Several successful pilot programs suggest that incentives for more rapid reemployment can reduce both the length of unemployment and the cost of paying benefits. For example, an Arizona trial program that provided more services to unemployed workers saved about $10 in benefits for every $1 spent administering the program. Elsewhere, a consortium of employers providing work search assistance to laid off workers is saving roughly $2 in benefits for each $1 the program costs. However, these experiments have been limited in scope. Much more needs to be done.

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