Designing Unemployment Insurance Programs
Transcript
Recently Oman announced the establishment of an Unemployment Insurance program. This is a great move for several reasons. First, Oman is making a shift towards diversification of its economic activity and the private sector will have a bigger role in the economy.
Second, a social safety net liberalizes the private labor market allowing for more flexibility with respect to labor decisions. Finally, economies experience business cycles, the ups and downs of the economy will impact individuals. Unemployment insurance allows for automatic stabilizers to smooth consumption and sustain spending. For example, an unemployment insurance program would have been helpful in the current COVID experience.
I have received many requests for more information on UI programs and how to analyze them. Today, I would like to take the time to discuss Unemployment Insurance programs and how to design them. This is a complicated matter, but I want to go through some of the highlights so that we are all informed about what UI programs are and how to navigate the pros and cons of unemployment insurance.
When designing unemployment insurance program you want to consider
The benefit
The contribution or funding into the program
Eligibility
Application Process or Administrative Burden
Before we get started let us define what unemployment insurance is. Like any insurance you are protecting yourself against the probability of an undesirable outcome. For UI you are protecting your income in the event that the economy goes through a recession.
Like any policy, UI has costs and benefits.
Free market economists would argue that a UI system is unnecessary. If everyone considers their own risk and saves their money for possible unemployment spells, then there is no need for government to interfere.
On the other hand, Economist that argue for UI do so because they believe this market fails. The uncertainty and lack of information about business cycles, and the unpredictability of them makes it difficult to plan. Also benefits to consumption smoothing help the entire economy, so there are positive externalities.
Most world economies have UI programs, but they vary in how they are designed. I would like to talk about the features of UI programs and the policy options available.
The first question is who qualifies for unemployment insurance. Most UI programs are designed to insurance against economic downturns. To qualify you must have lost your job because the firm is no longer in business or you were laid off due to downsizing. UI programs do not cover those that lost their job for cause.
There are requirements for who qualifies based on the duration of their previous employment or and contribution to the UI system.
The United Kingdom requires you to have been employed in the system for 12 months in the past 2 years. The US requires 20 weeks of employment and a minimum earnings threshold to qualify for unemployment insurance. Iceland requires employment for 10 weeks in the past year. Australia has no requirements.
Once we decided on who qualifies we need to define the benefit. That means we need to define How much will they receive and for how long.
The main issue with designing an UI program is designing the payout or benefit. The payout must balance between two objectives. You want the payout high enough to allow of consumption smoothing, but you don’t want it to be too high that it introduces moral hazard. Moral hazard is present because UI recipients might not search for a job as intensely if their income is being replaced. So policymakers have to design a system that balances these two possible outcomes.
When designing a UI program, you have to also decide on which income are you replacing.
The Omani proposal is to replace the average income of the past 24 months. The qualifying condition or contributions vary drastically around the world.
Hungary uses the income from the past year. Czech Republic uses the income from the past 3 months. Sweden replaces your most recent income.
Once you decided on which income to replace you have to decide how much of it to replace.
The proposed policy in Oman is 60% of the average income from the past 24 months.
This is called a flat replacement rate. Replacement rates are easily adjustable but need to be transparent. Here is a graph of several replacement rates for international comparison. We can see that the rates vary across countries and across time.
UI programs can also have a declining payout rate with respect to income. The replacement rate starts off high at lower incomes and decreases as income increases and these programs can also have a maximum amount that UI recipients can receive
This is an example from the recent CARES act in the U.S which adjusted UI replacement rates. In the U.S UI replacement rates vary by state.
In this next figure we can see that replacement rates vary by hourly wages. This is an example of a declining replacement rate.
The next feature to discuss is duration of UI. Once again, you want to design a program that helps people while they search for a new job, but not create an incentive to stay on UI for too long.
There are drastic differences across the world on how long UI programs replace lost wages.
USA provides 26 weeks of UI benefits. Iceland offers 3 years. Finland has 500 days
We have talked about the benefits lets talk about how to fund these benefits. The proposed method in Oman would be through a 1% employee and 1% employer contribution. Therefore, each month the Unemployment insurance fund will be funded with 2% of all wages in Oman.
When designing a UI program, you want to pool all the risk and therefore want as many people contributing into the system. Private and Government employees must participate in the program.
Once again, there are variations in how different countries fund their UI programs.
One thing we need to keep in mind, is UI programs are funded during expansions and they are used during recessions. It is important to keep these funds secured when it seems that you need them the least.
The last thing I will discuss is policymakers can control how many people apply for UI programs through the design of the administrivia application process. Transparency of process, eligibility and turnaround time, are as important as the other features we discussed here.
This is a really quick overview of Unemployment insurance programs. Designing an effective program requires technical analysis, understanding of labor market, and the economics of business cycles. I want to be clear that this video provides a quick summary. As always, if you want to learn more and discuss UI programs, reach out.