Unemployment benefits and work disincentives

A couple of weeks ago the NZ Herald had a couple of (short) opinion pieces on the choice for beneficiaries between working and remaining on the benefit - one by Karen Pattie, and one by Lindsay Mitchell. Karen writes:

There is a large percentage of my clients who approach our service and ask us to look at the viability of returning to work -- single parents who are committed to getting off benefit and excited about the prospect of returning to work.

When we break down the in-work tax credit, the childcare subsidy, accommodation supplement and temporary additional support, it is not uncommon that the working single parent ends up with under $50 a week more in their hand.

We then look at transport, parking, appropriate clothing etc. for work. Work and Income will assist with a percentage of this cost, however, not the total cost, which then gets taken off the $50.

Then, school holiday programmes need to be paid for along with childcare, which is subsidised, and the $50 in hand is reduced further.

Given this, most of our clients still opt to return to paid work because we can see the benefits of work experience which may lead to better work opportunities. 

Lindsay writes:

A Blenheim single mother of three finds she is only $34 better off working. She says, "When you weigh it up, is it worth going to work? The Government is trying to get everyone off the benefit but there is no incentive to work."

Of course, the 'choice' between working and remaining on the benefit is only relevant when there are jobs available. However, I'm not going to talk about that aspect. Instead, I want to discuss incentives (or rather, the work disincentives that benefits create).

One of the topics we cover in ECON110 is the economics of social security. Part of that topic involves considering the incentive effects of having a social safety net. If there is no safety net (for the unemployed, for example), then there are high incentives to take any employment that is available. The alternative is trying to live on zero income, relying on assistance from friends and family or non-government organisations, begging, etc. When there is a social safety net (for the unemployed), then the incentives for work are reduced, because the income difference between working and not working is lesser.

A rational (or quasi-rational) beneficiary who is offered the opportunity to work will weigh up the costs and benefits of working rather than remaining on the benefit. The costs of working (compared with being unemployed) are mostly the foregone leisure time (less time with the kids, gardening, or playing XBox). The benefits include higher income. If the difference between working and not working is only $34 (as per the example above), then it wouldn't be surprising for that to be insufficient incentive to encourage people to work.

A couple of additional points are important. First, there are non-monetary benefits to working that must also be factored in. Working provides a sense of purpose and identity. It can increase life satisfaction. So, it might not be surprising that some beneficiaries would return to work even if the monetary benefits were lower than the costs. Second, there may be long-run impacts. For example, the initial job taken may lead to improved future job prospects. As Lindsay notes:

Moving into work may provide little financial gain initially. But the individual's sense of well-being and future prospects are improved.

How do we reduce the disincentive for beneficiaries to return to work? We first need to recognise that the disincentives arise in two ways: (1) the relative generosity of the unemployment benefit; and (2) the rate at which the benefit is reduced as the beneficiary earns other income.

So, the disincentive to work can be reduced if the unemployment benefit was less generous. Clearly there is a trade-off here - you probably want the benefit to be high enough to provide for a minimum standard of living; however, making it too generous (compared with, say, the minimum wage) reduces the incentives to work.

The disincentive to work can also be reduced by allowing the beneficiary to continue to receive a (reduced) benefit if they go back to work. So, rather than taking away the entire benefit if a person returns to work, you simply reduce their benefit by an amount that depends on how much other income they earn. This way, you ensure that beneficiaries who take on part-time work can still attain a minimum standard of living, and you ensure that beneficiaries who work are financially better off than those who don't.

The abatement rate (the rate at which benefits reduce due to other income) matters because unsurprisingly it also affects incentives by contributing to the effective marginal tax rate (the proportion of the next dollar earned that is lost to taxation, decreases in rebates, and decreases in government transfers, e.g. benefits). If the marginal tax rate for low earners is 20%, and the benefit abatement rate is 50 cents for every additional dollar the beneficiary earns, then the effective marginal tax rate is at least 70% - quite a high disincentive to work. And then you have to factor in that the beneficiary might also have to pay student loans or child support from that additional dollar, and they might face a reduction in accommodation supplement and family tax credits, etc. So, there's not likely to be much left over. However, if the abatement rate is too low, then a large proportion of low (and medium) income earners will be eligible for income support, and you start to affect the incentives for people who would otherwise be working full-time, etc. So, again there is a tradeoff.

Social security is fraught with incentive issues and tradeoffs. Striking the right balance is always going to be a challenge.