Compensating wage differentials and the optimal provision of unemployment insurance.

• Author: Anderson, David A.

1. Introduction

   Between 1970 and 1987 the number of workers covered by unemployment insurance nearly doubled,(1) and benefit payments increased from $3.8 billion to $14.2 billion annually. Economists attribute this increased coverage in part for the sizable increase in the long-run (natural) unemployment rate over the same period |17~. The adequacy of unemployment insurance benefits is a major social and political concern, with repercussions extending to individual welfare and to the profits and productivity of American industries. Yet there has been no statistical investigation to test the adequacy of benefit levels, or to determine the net financial burden on firms, taking the wage offset for benefits into account.

   Viscusi and Moore |22~ developed a test for the optimality of social insurance benefits based on the tradeoff between wages and workers' compensation benefits. Their argument states that if benefit levels were adequate, individuals would be willing to trade wages for benefits at an actuarially fair rate, adjusted for the level of insurance loading. If benefits were too low, individuals would be willing to forego more than the efficient amount of wages to increase the level of insurance. If benefits were excessive, an individual would not be willing to pay the efficient rate in exchange for increased coverage. This paper evaluates unemployment insurance benefits using a parallel approach, with further attention given to moral hazard considerations, and using an alternative risk measure that accounts for the average duration of unemployment spells as well as their frequency. The results of this research estimate the price that workers would pay to insure their income against unemployment in the presence of an efficient (competitive) insurance market. That price provides a reference point for implicit insurance rates as established under the existing unemployment insurance program. Related studies have considered the effect of unemployment insurance on wages. Topel |19~ used the pooled 1977-80 Current Population Surveys to estimate the impact of unemployment risk on wages, controlling for unemployment insurance (UI) benefits, as well as the effect of UI on the propensity for agents to enter and leave spells of unemployment (on which a large literature exists). He did not, however, evaluate insurance levels in regard to their optimal rates, or consider the net cost of the unemployment insurance system. Abowd and Ashenfelter |1~ estimated compensating wage differentials for anticipated unemployment risk using the Panel Study of Income Dynamics. Their study included UI benefits as a substitute for wages in the calculation of the effective hours of employment, without including them explicitly in the wage equation.

   Previous efforts to determine the adequacy of unemployment insurance evaluated benefit levels based on their effect on individuals' lifestyles. In one such study, the U.S. Department of Labor |20~ interviewed 1650 Arizona residents after 5, 13 and 25 weeks of compensated unemployment in order to measure changes in household composition, nonbeneficiary household income, "necessary and obligated" expenditures, reservation wages, savings, and outside assistance received. Although the welfare of social insurance recipients is of critical concern, it is unclear how to judge benefit levels with respect to the lifestyle adjustments they impose, and efficiency considerations are absent from such criteria.

   Section II of this paper outlines the structure of the unemployment insurance system. Section III derives the theoretically optimal wage-benefit tradeoff. Section IV describes the empirical analysis. Section V reports the results and discusses their implications. Section VI concludes the paper.

2. Unemployment Insurance Policies and Benefit Availability

   The federal-state system of unemployment insurance was established under the Social Security Act of 1935. Among social insurance programs it is second only to Old-Age, Survivors, Disability, and Health Insurance (OASDHI) in the extent of its coverage. Individual states are free to adapt their programs to suit their particular needs, and consequently, no two state laws are alike. Each state determines UI benefit levels based on the earned income of workers subject to minimum and maximum benefit amounts. Benefit ceilings are justified on the grounds that high-income workers should be better able to finance themselves during periods of unemployment |13~. Maximum benefit levels are so low, however, that the earnings of a majority of eligible workers in the 1986 Current Population Survey qualified them to receive the maximum benefit amount. Thus, most workers are paid on what is effectively a flat-rate basis. For workers whose earnings put them between the minimum and maximum benefit amounts, benefits range from 50-60 percent of their average weekly earnings, often measured over the quarter during which earnings were the highest.

   In 1988, state programs paid $12.6 billion in unemployment benefits. In the formal analysis that follows, it is assumed (for simplicity) that employers bear the full burden of the unemployment insurance costs incurred by their employees--a reasonable approximation of reality in most cases. Benefit payments are financed by employer contributions based on the first $7000 paid to each worker in a calendar year. In order to properly allocate the cost of unemployment benefits, every state determines employers' contribution rates based on an experience rating formula. As an example, 32 states use the reserve-ratio formula, under which the difference between an employer's contributions to the state benefit fund and the benefits received by that employer's workers is divided by their payroll to determine their reserve-ratio. Contribution rates are then assigned with an inverse relation to reserve-ratios. This formula is designed to insure that no employer will be granted a rate reduction unless the employer's total past contributions to the fund exceed total benefit payments to his or her workers.

   The administrative costs of the unemployment insurance system are covered in full by federal grants to the states, and financed with the 0.8 percent Federal Unemployment Tax. Thus all employee contributions to the UI system go towards benefit payments in that state. The total expenditure on unemployment insurance administration in 1988 was $1.6 billion, resulting in an average cost of 13 cents per dollar of benefits paid to employees.

   Table I. Unemployment Rate Ranges for Major Industries 1980-87 INDUSTRY UNEMPLOYMENT RATE Agriculture 10.5-16.0 Mining 6.4-17.0 Construction 11.6-18.4 Manufacturing 6.0-11.2 Transportation/Public Utilities 4.5-7.4 Wholesale/Retail Trade 6.9-10.0 Finance, Insurance, Real Estate 3.1-4.5 Services 5.4-7.9 Government 3.5-5.3 As unemployment insurance benefits are a valued component of worker compensation, we should expect accompanying compensating wage differentials.(2) The plausibility of workers taking UI benefits into account in their employment decisions is supported by the figures in Table I, which indicate the range of unemployment rates in nine major industries over the 1980-87 period. As many as one-sixth of the workers in less stable industries were unemployed at any given time, and the average unemployment spell lasted 15.3 weeks. The variability in maximum and minimum benefit levels across states is evident in Table II, where benefit limits for 1989 are seen to differ by over 100 percent. Although the considerable variance in state UI benefit levels may induce workers in high unemployment industries to shop across states for a preferred wage-unemployment risk-benefit bundle, interstate migration is not necessary to allow workers to experience the wage-benefit tradeoffs discussed in this paper. Within a given state, jobs with differing wage and job-security levels will be within the workers' choice set. The expected replacement rate |risk*(benefits/wages)~ varies with wage and risk to produce the same effect as an increase in the benefit level, holding wage and risk constant.(3) The wage response to changes in the expected replacement rate can then be used to estimate the dampening effect of UI...