Labor Supply Effects of Social Insurance Alan B. Krueger Princeton University and National Bureau of Economic Research and Bruce D. Meyer Northwestern University and National Bureau of Economic Research February 2002 This paper was prepared for the Handbook of Public Economics, Alan Auerbach and Martin Feldstein, editors. We thank Melissa Clark, Kenneth Fortson, Jeegar Kakkad and Bradley Heim for helpful research assistance and David Autor, Bertil Holmlund and Peter Orszag for helpful comments. We also thank Alan Auerbach for his patience and persistence in waiting for this chapter, and helpful comments. 1. Introduction This chapter summarizes evidence on the labor supply effects of social insurance programs. One may ask, “Why is a separate chapter necessary on the labor supply effects of social insurance? Why can't the labor supply parameters estimated in the voluminous labor economics literature just be plugged into the social insurance formulas?” In our view, a separate consideration of the labor supply effects of social insurance is justified for at least three reasons. First, the generic labor supply parameters estimated in the public finance and labor economics literatures may not apply to social insurance programs because people are imperfectly informed as to the rules of the programs, or because the parameters may differ for those who are eligible for social insurance programs (i.e., heterogeneous parameters) than for the population at large. For example, a severe disability may change the way an individual perceives the trade off between labor and leisure time. More generally, the people who are on the margin of going on a social insurance program are likely to have different preferences than the wider population. Second, the labor supply elasticities estimated in the labor economics literature span a huge range. Literature surveys such as Pencavel (1986) and Killingsworth (1983) find wide diserpsion in estimates of income and substitution effects. Fuchs, Krueger and Poterba (1998) also find that there is little agreement among economists on the magnitude of labor supply elasticities. A major shortcoming in the broader labor supply literature is that it is difficult to identify exogenous changes in wages or income that can be used to estimate labor supply responses. The variations in social insurance programs may provide natural experiments with which to estimate labor supply parameters and test the relevance of labor supply models. Third, the design of social insurance raises several theoretical labor supply issues that are 2 not often dealt with in the standard labor supply literature. For example, the prospect of receiving Social Security benefits in the future may induce some young people to enter the work force, while the provision of benefits may induce older workers to leave the work force. Moreover, much of the labor supply literature deals with adjustments in the number of hours worked per week or number of weeks worked per year, whereas the incentives of social insurance programs often affect the decision of whether to participate at all in the labor force. And programs such as Unemployment Insurance (UI) influence job search intensity, which does not figure into standard labor supply models. To summarize the impact of social insurance on labor supply, it is necessary to have a working definition of what is meant by "social insurance." There is no official definition. For our purposes, social insurance programs are defined as compulsory, contributory government programs that provide benefits to individuals if certain conditions are met. For example, upon turning age 62 eligible individuals may receive Social Security benefits in the United States. In general, social insurance programs are funded by dedicated taxes or premiums, and have compulsory coverage. Benefits are generally restricted to those who contributed to the program's financing. Under this definition, for example, Medicare is social insurance but Medicaid is not because Medicare receipt is limited to qualified individuals who contributed to the program while Medicaid receipt is available to all individuals with sufficiently low income. Other programs that are considered social insurance include: Social Security retirement benefits, Disability Insurance (DI), Unemployment Insurance, and Workers' Compensation (WC) 3 Insurance. These programs form the basis for this chapter.1 Although other programs could be classified as social insurance, such as the Railroad Employee Retirement program, these four programs are the four largest social insurance programs in the U.S., and illustrate many of the lessons that can be learned of the effect of social insurance on labor supply. In practice, social insurance programs are the way society typically pools risks for events that have catastrophic consequences (e.g., severe work-related injuries), or events that individuals may not plan for adequately on their own (e.g., retirement). More generous benefits will provide greater protection against risk, but would likely generate larger distortionary effects. For example, generous Unemployment Insurance benefits insure workers against the earnings losses that accompany job loss, but also induce some workers to search less intensively for a new job. A great deal of research has focused on identifying and quantifying the intended and unintended consequences of social insurance. Because the receipt of social insurance is often triggered by withdrawing from work, and because the programs are typically funded by taxes on labor, a major avenue in which social insurance has its intended and unintended consequences is through altering labor supply. Another realm in which social insurance can be have an unintended effect is on savings: individuals may not save as much to offset the adverse consequences of negative events if they are insured against those risks by social insurance. See the chapter by Feldstein and Liebman in this volume for evidence on the impact of Social Security on savings behavior. Ideally, one would like to balance the intended consequences against the unintended consequences of social insurance to design the optimal benefit level. Determining the optimal 1For the most part, the review focuses on U.S. social insurance programs, but we draw on programs in other countries when the evidence is particularly strong and germane. 4 balance requires knowledge of the distortionary effects of social insurance as well as the beneficial insurance effect. The labor supply response to benefits is an important input into this calculation. Gruber (1997), for example, provides an exemplary evaluation of the tradeoff between the consumption smoothing benefit of the UI program against the undesired distortion to job search intensity caused by the provision of benefits. Knowledge of the labor supply effects of social insurance is required for governments to optimally design the programs. The provision of social insurance is a major government function. Figure 1.1 displays the percent of the U.S. federal government budget devoted to social insurance expenditures each year since 1967.2 In 1967, 15 percent of government expenditures consisted of social insurance outlays. By 1996, social insurance expenditures rose to one third of total government spending, and in 2007 social insurance benefits are predicted to top 44 percent of government spending. The growth in social insurance spending is primarily a result of demographic shifts (e.g., an aging population), increases in program generosity, rising health care costs, and behavioral responses to program changes. Paul Krugman (2001) did not exaggerate when he observed, “loosely speaking, the post-cold-war government is a big pension fund that also happens to have an army.” The U.S. is not unique in devoting a great deal of the government budget to social insurance. The first column of Table 1.1 reports the percent of social insurance spending as a percent of GDP in eight countries, which were selected because they span a wide range of economic development and had available data. The next two columns report social insurance 2Here social insurance includes Old Age Survivors and Disability Insurance, Medicare, Workers’ Compensation Insurance and Unemployment Insurance benefits. 5 expenditures as a percent of the central government’s budget and as a percent of the budget in all levels of government. The social insurance expenditure data are from the International Labour Organization, and cover a broader range of activities than the measure used in Figure 1.1. In social democratic countries like Sweden and Germany, social insurance expenditures represent a much greater share of government and economic activity than they do in the U.S. In developing countries, social insurance expenditures are a smaller share. Transitioning countries, such as the Czech Republic, appear to be an intermediate case. Social insurance expenditures are surprisingly low in Japan, reflecting in part that country’s meager public pension system. Overall, the table gives the impression that social insurance is a normal good, representing a higher share of the government’s budget and economic activity in wealthier countries.3 Not surprisingly, social insurance expenditures have risen over time in many countries as well. It is natural to question whether the increase in expenditures on social insurance programs has influenced the declining trend in labor force participation. Figure 1.2 illustrates long-term trends in labor force participation of older men in the U.S. using a series developed by Moen (1987) and Costa (1998).4 The figure shows the percent of men age 55-64 or 65 and older who are gainfully employed each Census year. Employment has declined considerably for older men since the beginning of 20th century. Similar -- and in some cases sharper -- downward trends 3Looking across countries, Rodrik (1997) and Agell (1999) find a positive relationship between the generosity of a variety of social welfare benefits and the openness of the economy, suggesting that social insurance is demanded, in part, to dampen the risk associated with trade shocks. 4Quinn (1999) finds that the downward trend in labor force particpation of older workers has levelled off or reversed since the mid 1980s. Although this is a very interesting development, our interest here is in the longer term pattern. 6 have occurred in other industrialized countries. The declining employment of older men raises three issues of concern for public economics: first, a smaller proportion of the workforce is available to contribute support for social insurance and other government programs; second, more individuals receive Social Security retirement benefits, raising the need for tax revenues; and third, social insurance may distort the economy by inducing some individuals to exit the labor force prematurely.5 An earlier wave of studies (e.g., Parsons, 1980 and Hurd and Boskin, 1984) attempted to explain the fall in aggregate labor force participation by rising social insurance benefits. As social insurance consumes an even larger share of government budgets, and as the size of the working-age population declines relative to the nonworking-age population, understanding labor supply responses to social insurance will take on even greater importance. The organization of the remainder of this Chapter is as follows. We first discuss Unemployment Insurance in Section 2, beginning by describing the main program features and how they differ across the states. We also provide some brief information on programs in Canada and other countries. We then discuss the main effects of UI on labor supply, first from a theoretical perspective and then by reviewing the empirical evidence. Section 3 follows the same pattern for Workers’ Compensation. We begin by describing the main characteristics of state programs, and then lay out the theoretical predictions and empirical evidence on labor supply responses. In Section 4 we examines Social Security. We describe the theoretical predictions and empirical evidence on labor supply effects. We end this section with a discussion of the timing of retirement and the effects of the earnings test. In Section 5 we examine Disability 5For a more benign interpretation, see Burtless and Munnell (1991). 7 Insurance. We describe the operation of the program and then analyze the evidence on its role in explaining trends in labor force participation and self-reported disability rates. Section 6 provides our conclusions. 2. Unemployment Insurance Unemployment insurance is one of the most extensively studied government programs in the U.S. and elsewhere. Before describing the main features of UI programs and their labor supply effects, we should note that there are several excellent prior surveys of UI.6 Though many of the surveys cover a wide range of issues, they generally emphasize the labor supply effects of UI. 2.1 Main Features of U.S. Unemployment Insurance Programs UI programs differ sharply across states due to the provisions of the Social Security Act of 1935 which created the current system and gave states great latitude in designing their programs. State UI programs differ in the earnings required for eligibility, the level of benefits (the replacement rate, the minimum and maximum benefit), the potential duration of benefits, and other parameters. Table 2.1 reports key features of twelve state programs in 2000. It is apparent from this table that there are large differences in program parameters across states. These cross-state differences and their frequent changes over time have been a fundamental 6See Hamermesh (1977), Welch (1977) , Danziger, Haveman, and Plotnick (1981), Gustman (1983), Atkinson (1987), Atkinson and Micklewright (1990), Devine and Kiefer (1991), Anderson and Meyer (1993), and Holmlund (1998) for surveys of the UI literature. 8 source of the identifying variation used to estimate the effects of these programs. Approximately 97 percent of all wage and salary workers are in jobs that are covered by unemployment insurance. The main categories of workers not covered are the self-employed, employees of small farms, and household employees whose earnings are below the threshold amount. Despite this near universal coverage, less than forty percent of the unemployed received UI in many recent years.7 The cause of this low rate of receipt is largely that individuals who are new entrants or reentrants to the labor force, who have irregular work histories, and individuals who quit or are fired from their last job are typically not eligible for benefits. Such individuals are frequently excluded by minimum earnings requirements for eligibility ranging from $130 in Hawaii to $3,400 in Florida, with a typical state requiring previous earnings just over $1,500.8 UI benefits are paid on a weekly basis, and except for minimum and maximum benefit amounts, are usually between 50 and 60 percent of previous earnings.9 All states have a maximum weekly benefit amount, which varies from a low of $190 in Mississippi to over $600 in Massachusetts if dependents’ allowances are included. The median state had a maximum benefit of about $292 in 2000. About 35 percent of claimants receive the maximum benefit. For these individuals, the fraction of their previous earnings replaced by UI can be much lower than 7See Blank and Card (1991) and Anderson and Meyer (1997) for studies of the reasons for the low rate of UI receipt. 8More precisely, earnings during the first four of the five full calendar quarters prior to the quarter an individual files for benefits. Five states now use alternative time frames that differ from this rule. 9A typical benefit schedule would compute the weekly benefit amount as high quarter earnings divided by 23. High quarter earnings are typically the highest calendar quarter of earnings during the first four of the five full calendar quarter prior to the quarter an individual files for benefits. 9 50 percent. The minimum weekly benefit is typically very low; the median state has a minimum of about $39. In almost all states, benefits last up to 26 weeks. However, in all but eight states, total benefits paid are restricted to some fraction of previous earnings or weeks worked. Table 2.1 indicates that a typical state requires just over 3 quarters (39 weeks) of work for a claimant to be eligible for 26 weeks of benefits. This provision causes the potential duration of benefits to be less than 26 weeks for approximately half of all recipients.10 In all but 11 states, there is a waiting period of one week after the beginning of unemployment until one can receive benefits. In 1970, a permanent Federal-State extended benefits program was established to provide additional weeks of benefits to individuals who exhaust their regular State benefits in periods of high unemployment. When a state's insured unemployment rate is sufficiently high, weeks of benefits are extended 50 percent beyond that which an individual would be entitled to under State law, with the extension not to exceed 13 weeks. In addition, in times of high unemployment Congress has typically passed ad hoc laws temporarily extending benefits further. Because the unemployment rate has been low in recent years, benefits have only rarely been extended, despite a change that relaxed the threshold for benefit extensions in 1993. Prior to 1979, UI benefits were not subject to Federal income taxation, but in 1979 they became taxable for high income individuals. In 1982 taxation of UI was extended to most 10A typical state calculates potential weeks of benefits as the minimum of 26 and base period earnings divided by three times the weekly benefit amount. Base period earnings are usually calculated as earnings during the first four of the five calendar quarters prior to the quarter an individual files for benefits.