Unemployment Insurance in a Free Society

Policy Reports | Welfare

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

Problems with the Current Unemployment Insurance System

Figure I - Increase in Temporary Layoffs Due to Imperfect Experience Rating

The nation’s unemployment insurance system changes behavior in harmful ways: It encourages employers to lay off workers and discourages unemployed workers from looking for new jobs. Furthermore, it treats some workers unfairly. And it provides no incentives to improve system efficiency.

“The system creates perverse incentives for employers to lay off workers.”

Encouraging Layoffs. The unemployment insurance system increases unemployment by creating perverse incentives for employers to lay off workers. It does so by shielding employers and their workers from the true cost of layoffs. Under current tax codes, an individual firm’s tax rate is adjusted according to how many of their laid off workers file claims for benefits. This experience rating varies from state to state, however, and all states have floors and ceilings on the tax rates. As a result, there is no penalty when a company already paying the maximum tax rate lays off one more worker. Even a company paying the minimum tax rate may not be penalized by a small layoff. Also, the tax schedules in some states are not actuarially related to the costs different employers impose on the system. Thus, the system itself insulates many companies from the economic impact of their own layoffs.

“It reduces the need for seasonal employers to pay a wage premium or provide off-season employment.”

This is especially true for businesses with a variable need for labor. These firms may be in very cyclical industries, such as capital goods manufacturing, or in seasonal industries such as food processing. If not for the safety net of unemployment insurance, these employers would have to offer a wage premium to attract employees from other employers who offer year-round, regular employment. To minimize the size of the wage premium, employers would seek ways to stabilize their employment. For instance, a company that normally produces goods after an order is received, might produce in advance, anticipating inventory needs during slack times. Or, a company that would otherwise contract out for equipment renovation might train production workers to do the job in-house during the off season. Unemployment insurance reduces or eliminates the need for these employers to pay a wage premium or provide off-season employment. Figure II - Duration of Unemployment

“During the depths of a recession, the system itself may cause as much as 50 percent of all temporary layoffs.”

All of the econometric studies on the subject have concluded that the unemployment insurance system in the United States induces layoffs. Figure I, which summarizes the results of these studies, shows that during the depths of recession, the system itself may cause as much as 50 percent of all temporary layoffs. 1

“The system imposes a 50 percent tax on low-wage workers who find a new job.”

Discouraging Job Search. Unemployment insurance benefits discourage unemployed workers from actively seeking a new job. For instance, until low-wage workers exhaust the benefits, their loss upon reemployment acts as a 50 percent tax, in addition to all other taxes. Since leisure itself is valuable, an individual may prefer not to work while benefits are available rather than receiving twice as much pre-tax income while working.Thus the way benefits are paid is itself a disincentive to reemployment. Research supports the idea that the unemployed respond to these economic incentives:

  • Workers eligible for UI benefits are unemployed longer than those who are ineligible. 2 [See Figure II.]
  • Workers who are offered bonuses for rapid re-employment find work faster than typical workers receiving unemployment benefits, and their new wages are slightly better (contradicting the claim that longer job searches produce better-paying jobs).
  • The probability of an unemployed worker finding a job rises dramatically the week before the end of the person’s eligibility for unemployment insurance. 3 [See Figure III.]

“The probability of finding a job rises dramatically the week before unemployment insurance benefits run out.”

Studies of other developed countries, including Canada, Spain and Sweden, and of Europe generally, have come to similar conclusions. 4

It is commonly assumed that the unemployed cannot find work until there is a net gain of employment in the economy. Reality is quite different. Normal turnover occurs all the time: people retire, quit for personal reasons or are fired for cause. There is also job churn, in which some companies expand and others are newly formed at the same time that other firms contract or die. Both turnover and churn create far more job opportunities than net new employment. For example, more than 50 percent of workers in Oregon were newly hired during a year in which net job growth was only two percent. 5 Since there are many job openings, an unemployed person can substantially hasten his or her reemployment through more active work search.

Figure III - Likelihood of Reemployment

The intensity of job search is a major factor affecting how long a person remains unemployed. It is certainly the major factor that the unemployed person controls. Search intensity will vary even among people who are in their prime working years and the sole support of their families. Consider an unemployed person’s work search effort. Suppose that on Monday morning he writes a letter in response to a classified job ad; he calls a friend to ask if there are any openings with the friend’s employer; and he visits a third company and fills out an application. It’s now noon on Monday. What does our job-seeker do? He can wait to see if any of these three inquiries bear fruit, or he can spend his afternoon making more inquiries. It is human nature to put off the things that we don’t care to do, things that make us feel uncomfortable or embarrassed. One doesn’t have to label a person “lazy” to see human nature at work. We have all put off tasks that we find distasteful, even if necessary.

“Unemployment insurance taxes workers who are ineligible for benefits.”

The disincentive effect of unemployment benefits probably has the greatest impact on individuals at the margin of the employment decision. 6 They are at the margin because they value other uses of their time almost as much as work. These include mothers with small children, students and retirees. [See the sidebar: Decisions at the Margin.]

Figure IV - Average Length of Unemployment

“Those who stay consistently employed receive no benefit for the taxes they pay.”

A small subset of the millions of workers who file unemployment claims each year will remain unemployed a year or more. The longer a person is unemployed the more difficult it is to become reemployed — due to the loss of work habits, outdated skills or growing gaps in the work history. Some job seekers mistakenly think a longer work search will lead to a higher-paying job. Yet empirical research shows that it does not. 7 On occasion, Congress has extended unemployment benefits in regions or states that have higher than average unemployment rates. Congress also created a special program, Trade Adjustment Assistance, which pays benefits to workers displaced by foreign competition for up to two years. Such extended benefits, however, contribute to the problem of long-term unemployment. In countries that provide more generous benefits than the United States, and do so for two or more years, the average length of unemployment is much longer. 8 [See Figure IV.]

“The average length of unemployment is much longer in countries that provide more generous benefits.”

Treating Workers Unfairly. The unemployment insurance system treats many workers unfairly. It taxes workers who are ineligible for benefits, and those who stay consistently employed receive no benefit in exchange for the taxes they pay. The length of time an individual receives benefits often depends on factors beyond his or her control, such as at what point during a business cycle the layoff occurs, and how many other workers in the state are unemployed. Ironically, the current system often does not provide benefits to some low-wage workers. This occurs because in order to qualify for benefits, workers must have a minimum employment history. Thus, workers who are employed seasonally, in cyclical industries, or only part-time may not qualify for benefits, even though their wages were taxed to support the system.

“The average state loses about 9 percent of its funds to erroneous or fraudulent benefit claims and payments.”

Encouraging Inefficiency. The current system provides no incentives to state agencies to reduce administrative costs or fraudulent claims, or to speed up reemployment. Yet there are potential cost savings in each of these areas. The average state loses about 9 percent of its funds to erroneous or fraudulent benefit claims and payments, and some states lose nearly 20 percent of their funds. 9 Workers who quit voluntarily or are fired “for cause” are usually ineligible for benefits. However, settling benefit disputes requires a system to adjudicate claims. This delays benefit payments and adds to overhead costs. In one state, for example, the cost of determining whether a worker’s job separation qualifies for benefits and adjudicating disputed claims adds up to 22 percent of the state’s total administrative costs. A separate federal unemployment tax trust fund reimburses state administrative costs, which were $3 billion in 2002. These funds cannot be used to pay benefits, and benefit funds cannot be used for administration. The inflexible wall between the two funds means that a state cannot use benefit funds to pay for administrative initiatives — such as work search assistance — that could eventually save benefit funds. This reduces states’ ability to deliver services more efficiently.

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