Unemployment Benefits: When More Is Not Always Better

EspañolThe latest proposal to extend federal unemployment benefits again — up to a maximum of 77 weeks — begs the question: is more always better? In the social sciences the notion that more is not always better is known as the Inverted “U” hypothesis.

Inverted-U curves have three parts: (1) the left or ascending side, where more resources make things better, (2) the middle of the Inverted-U, where more resources do not make much of a difference, (3) and the descending right side, where more resources make things worse. The logic of the Inverted-U curve is that there comes a point when, notwithstanding the intentions, adding resources only functions to make things worse. Scientists argue that nearly all experiences follow an Inverted-U.

Inverted U Curve
Inverted-U curve.

Let’s apply this insight to the unemployment benefits debate.

The federal-state unemployment insurance system was established in 1935 to serve as a safety net, providing temporary financial assistance to workers who lose their jobs. Initially, unemployment compensation benefits were to be funded by payroll taxes on employers. However, the system has evolved to using general federal revenues to pay for an expanded range of benefits. At first, benefits were to last 16 weeks, but were later expanded to 26 weeks, and over the years “supplemental” benefits have been added to the proposed span of 77 weeks and counting.

Protecting workers from the vicissitudes of fortune may appear a noble idea, but there are unintended consequences. The first consideration should be whether shielding us from the vicissitudes of fortune is a legitimate function of government, but let us put that philosophical question aside for another day to focus now on unemployment insurance.

Research shows unambiguously that unemployment insurance encourages individuals to remain unemployed longer by providing an incentive and the means to not work. To be clear, this is not a disparaging assessment. It is a factual statement of a logical human reaction to a particular stimulus.

One reason is that unemployment benefits increase what economists label as a worker’s “reservation wage.” This reservation wage is the minimum wage someone insists on getting before accepting a job, and it takes into account the difference between the government benefits and the amount that would be paid by an employer. As a result of receiving unemployment compensation, workers may decline job opportunities when the job does not provide a significant increase in monies received.

Other studies show that some workers may stay out of the job market to maximize the benefits received. This genre of research typically shows a sharp increase in re-employment just before unemployment benefits run out.

Do you see an inverted-U relationship here?

Proponents of extended unemployment payments argue that these payments serve to stimulate the economy by providing purchasing power to the unemployed. They forget to mention that in order to make these payments, the government must take resources away from employed workers via taxation, thus reducing the purchasing power of the employed. In aggregate economic analysis the income effect of such transfer payments is always zero. Alternatively government may borrow to make the payments, but that only shifts the loss of purchasing power to future workers.

Even more egregious is the argument that unemployment compensation payments offer a multiplier effect such that for every dollar paid the economy is stimulated by a greater amount, say $1.80, as the money travels from one recipient to another. If this were true, we could double our Gross Domestic Product by all stopping work and receiving unemployment compensation — unmitigated nonsense.

Even so, if as a society, we are persuaded that it is desirable to orchestrate a safety net for workers, there are far better approaches. One example is the program enacted in Chile. The Chilean system centers on personal unemployment-insurance accounts. These personal accounts are funded by an employer payroll contribution just as ours are; the difference is that the accounts are owned by the individual worker and accumulate balances over the worker’s career. Unused funds are the property of the worker and can be used to complement retirement savings.

Notice that these personal unemployment insurance accounts remove the disincentives inherent in our system since workers are motivated to find new employment as quickly as possible to preserve their account balances. At a minimum, it is a system that stops making things worse and moves resources from the descending to the ascending side of the Inverted-U curve.

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