EUROPEAN PAPERS ON THE NEW WELFARE

Abstracts from The Employment Dilemma and the Future of Work

7.2 The negative income tax

The negative income tax aims to provide a viable solution for the problem of how to organise a basic income system efficiently. It constitutes an alternative much in the spirit of the preceding chapter, relieving our society of the perverse effects of the current social security system on economic efficiency and the social structure. It would not only be easier to manage and therefore cheaper to organise but also more humane since it would replace the current incoherent set of income support and welfare systems with a single concordant program of monetary assistance. Any disincentives to work inherent in so many other schemes could be reduced through the adequate introduction of a negative income tax.
The negative income tax is a noncategorical welfare program that depends only on income and not on other characteristics of an individual such as age, marital status, disability etc. Any individual that does not have an income receives some basic grant, those with modest levels of income receive lesser supplements in such a way as not to hurt the incentive to work more. This can be achieved by permitting the individuals to keep most their earnings while gradually phasing out additional monetary support. In this way the feared poverty trap, a situation where the withdrawal of financial support compensates or overcompensates additional earnings leaving the individual worse off than if he had not worked, can efficiently be evaded.
Critics of the negative income tax argue that it would undermine the work ethic, resulting in reductions in the work effort of the affected people. This adverse situation, however, is very much subject to the level of benefits granted. If they are too generous, people will opt not to work or work less, as a real-world experiment in New Jersey demonstrated. The question is therefore rather one of fine-tuning the negative income tax system in such a way as to avoid impact on working morale. The second criticism about the high costs of this system is more about ethics than economics since it rises the question whether people should be left living under the poverty line — even if they could be helped — for the sake of improved market efficiency. The current welfare provisions do not comprise every needy person in hardly any industrialised country and is therefore cheaper than an alternative that would reach everyone in need.
Still another mechanism is proposed by Gary Becker: the Earned Income Tax Credit (EITC). He maintains that this system would be a wonderful “alternative to both a higher minimum wage and an extensive welfare program sharply [… targeting] poor families without reducing employment, encouraging a welfare mentality or rising governments spending5.” The EITC is family based and works as follows: until a given limit of family income, the family receives an additional credit equal to 40% of its income. With higher income this credit phases out until finally the family receives no tax credit at all.
Becker judges this system as superior to others since it rewards rather than penalized poor families with working members. It evades the disadvantages of rising minimum wages, it does not affect the incentives of companies to employ workers with few skills and it even increases the incentives of the less skilled to get training. However, the moral hazard component that is inherent in all systems like Becker’s cannot entirely be eliminated. When the subsidy phases out and then disappears at a certain level, there is moral hazard present. The impact of this moral hazard on human behaviour can only be guessed. From our point of view we welcome this proposal since it is an interesting approach to subsidise work and not idleness, a concept which we regard as of utmost importance.

7.3 Incentives and moral hazard effects of unemployment benefits

Most industrialised countries have arrangements that permit the payment of unemployment benefits in one form or another for different periods of time to most groups of unemployed people. Some schemes offer all eligible individuals the same fixed money sum while others tie the level of benefit to an individual’s previous earnings and replace a certain proportion of these, usually subject to an upper ceiling. The entitlement rules vary considerably from one country to another but usually involve a minimum time of more or less regular contribution and a disqualification or reduction in the case of voluntary redundancy. Unemployment benefits are subject to eligibility conditions which state that claimants must be available for work, willing to work and co-operate with the public employment services.
The rationale for unemployment benefits is to relieve people who have lost their job through no fault of their own, hence voluntary unemployment is usually excluded, from immediate financial concerns, thus allowing for a more efficient job search. These benefits, therefore, have an economic as well as a social equity objective, e.g. reducing poverty among the unemployed and cushioning the adverse effects of high and rising unemployment.
With unemployment rates often approaching or, in unfortunate cases, exceeding 10%, the relatively generous provisions have typically led to expenditures equal to 2% of GDP for income maintenance. These comprise all forms of cash benefit to compensate for unemployment, except early retirement. In addition to unemployment insurance and assistance, this covers publicly-funded redundancy payments, compensation to workers whose employers go bankrupt and special support of various groups such as construction workers laid off during bad weather.
While on the one hand public employment services provide many incentives to attract people back to the labour market, helping them in their search for a new job, on the other hand, generous provisions always entail a certain risk of moral hazard and abuse, and may even lead to benefit fraud. The unlawful actions include false declarations, claiming benefit while not being available for work, not actively searching for work as required by legislation, non-declaration of earnings from casual work by benefit recipients or multiple claiming of benefits to name just the more common. The public employment services tries to enforce eligibility for benefits effectively through adequate control and other measures, thus preventing — to a certain extent — improper or illegal actions by the unemployed. Specific acts like the refusal to take up suitable work, in some cases even if at a lower qualification level than desired by the unemployed, or the rejection or non-attendance of training courses usually lead to temporary and upon repetitive refusal to permanent suspension of benefits.
The problem of moral hazard is substantially different from benefit abuse or fraud. It occurs when individuals change their behaviour due to the existence of an insurance or benefit system in such a way as to become or stay eligible without infringing the law. In many cases an individual’s employment status is under his control, since a worker’s behaviour can influence the chances that he will lose his job. Similarly, an unemployed person can control the intensity with which he seeks a new job while receiving unemployment benefits. People might behave in such a way as to gain from becoming or staying unemployed. This gain not necessarily has to be in financial terms, since individuals could opt to accept more leisure time and reduced compensation through the benefit system instead of less leisure time and higher income through remunerated work.
The question of whether and to what extent the moral hazard problem of unemployment benefit systems is prominent cannot easily be answered since these systems are multidimensional and difficult to characterise in a single indicator. But it seems that higher replacement rates, and the ratio of income which is received when unemployed to that which could be received in employment, correlate positively with longer duration of unemployment6. Some studies have concluded that there is, others that there is no cross-country correlation between unemployment benefits and aggregate unemployment, thus largely ruling out a moral hazard effect. However, negative findings may be misleading because simple measures of benefit generosity have been used, because there might be a reverse causality present or because cross-country relativities in unemployment rates have changed considerably during time7. The OECD concludes that although earlier research did not detect a significant cross-country correlation between benefits and aggregate employment rates, more recent regressions, modelling unemployment as a lagged function of benefit entitlements, suggest that replacement rates and duration of benefits affect unemployment rates. They also report that high benefit entitlements may not only affect long-term unemployment but may encourage short employment spells, voluntary job-leaving, and involuntary part-time unemployment. It is as if the moral hazard problem were inherent in the actual unemployment benefit systems and not negligible.

5 Becker, G. (1996): “How to End Welfare ‘As We Know It’”, Business Week, 3 June 1996, p. 8.
6 See e.g. Meyer, B. (1990): “Unemployment Insurance and Unemployment Spells”, NBER Working Paper 2546. Or Johnson, G. and Layard, R. (1986): “The Natural Rate of Unemployment”, in Ashenfelter, O. and Layard, (1986): R.: The Handbook of Labour Economics.
7 According to OECD (1994): The OECD Jobs Study. Part II, chapter 8.


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