The Effect of Unemployment Insurance on Unemployment
By David Henderson
Does standard microeconomics fail when there’s a recession?
Last week, I addressed the issue of how much of the current unemployment is due to the many extensions of unemployment benefits. In some states you can now receive benefits for as much as 99 weeks, just shy of two years. To put that in perspective, we have never been there before. In the early 1980s, the longest anyone could receive such benefits was, I believe, 55 weeks. So this almost an additional year of benefits and it puts us in the same league as much of Western Europe.
There is much agreement among economists about the microeconomics of unemployment benefits, and it’s worth reviewing why. I could lay it out fresh but Larry Summers said it quite clearly in his article on unemployment in my Encyclopedia. Here’s Larry:
Each unemployed person has a “reservation wage”–the minimum wage he or she insists on getting before accepting a job. Unemployment insurance and other social assistance programs increase that reservation wage, causing an unemployed person to remain unemployed longer.
Consider, for example, an unemployed person who is accustomed to making $15.00 an hour. On unemployment insurance this person receives about 55 percent of normal earnings, or $8.25 per lost work hour. If that person is in a 15 percent federal tax bracket and a 3 percent state tax bracket, he or she pays $1.49 in taxes per hour not worked and nets $6.76 per hour after taxes as compensation for not working. If that person took a job that paid $15.00 per hour, governments would take 18 percent for income taxes and 7.65 percent for Social Security taxes [DRH note: this should be Social Security plus Medicare], netting him or her $11.15 per hour of work. Comparing the two payments, this person may decide that an hour of leisure is worth more than the extra $4.39 the job would pay. If so, this means that the unemployment insurance raises the person’s reservation wage to above $15.00 per hour.
Moreover, as some people have pointed out, Paul Krugman and Robin Wells, in their textbook, Macroeconomics, 2nd ed., 2009, agree with this reasoning. They wrote:
Public policy designed to help workers who lose their jobs can lead to structural unemployment as an unintended side effect. . . . In other countries, particularly in Europe, benefits are more generous and last longer. The drawback to this generosity is that it reduces a worker’s incentive to quickly find a new job. Generous unemployment benefits in some European countries are widely believed to be one of the main causes of “Eurosclerosis,” the persistent high unemployment that affects a number of European countries.
Krugman argues, though, that this reasoning doesn’t apply during a recession. He writes:
What’s limiting employment now is lack of demand for the things workers produce. Their incentives to seek work are, for now, irrelevant. That’s why comments by the likes of Sen. Kyl are so boneheaded — anyone who thinks that high unemployment in the first quarter of 2010 has anything to do with workers getting excessively generous benefits must not get out much.
I think we’re iterating. I think Krugman is right that lack of aggregate demand is the basic problem and I agree with Scott Sumner that the way to fix this is with monetary policy. But these explanations–lack of aggregate demand on the one hand and incentives for workers to take jobs on the other hand–are not mutually exclusive. Think through the microeconomics of what Larry Summers wrote above. For it not to apply during the recessions, it would have to be the case that workers literally can’t find jobs so that whether the benefit is zero or $500 a week, the person remains unemployed either way. Is it really plausible that this applies to all workers?
Ask yourself this. You lose a job that paid, say, $40K a year ($800 a week) before tax and now you can get $25K a year ($500 a week) before tax–and, moreover, you don’t pay the 7.65% employee portion of the payroll tax on that $500. You see a job that pays, say $30K a year. Do you think you might hold out for one that pays, say, $35K? There’s nothing in this analysis that says you’re lazy. What it says is that, in economists’ usage of the language, “You’re rational.”
Here’s the test: Can you find people getting unemployment benefits who have turned down jobs? If so, I’m right and Krugman’s wrong. If not, Krugman’s right and I’m wrong. For those who want to “get out much,” this is the thing to get evidence on.