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Solutions and Activities

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for
CHAPTER 14

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UNEMPLOYMENT INSURANCE, DISABILITY

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INSURANCE, AND WORKERS’ COMPENSATION

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Questions and Problems

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1. The unemployment insurance payroll tax is said to be partially experience-rated be-

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cause the tax rate on earnings is higher for firms with a history of laying off workers.

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What is the rationale for making the payroll tax rate a function of a firm’s layoff his-

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tory?

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Experience rating forces firms to bear some of the cost of laying off workers. In the ab-
sence of experience rating, firms would have an incentive to lay off and then rehire workers

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with greater frequency. Frequent layoffs and rehires without experience rating allows em-
ployees to benefit at no cost to the firm. To discourage firms from taking advantage of this
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implicit subsidy, experience rating increases their insurance premiums when layoffs occur.
This disciplines firms to hire only when the long-term prognosis of success is good and to
keep workers employed during seasonal, or other temporary, slack times.
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2. Describe the effects of raising the maximum benefit level for unemployment insurance
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on the savings rate of high-income workers. How big are the consumption-smoothing
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benefits of this policy change likely to be? Are there other potential benefits of raising
this maximum benefit level?
High-wage earners would receive more income in the event that they lost their job. This
means that they would have to do less “precautionary” saving (savings for the purpose of
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consumption smoothing after these events). Although this policy would presumably improve
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consumption smoothing among high-income workers, the benefit is likely to be relatively

small for at least two reasons. First, high-income workers presumably already had plenty of
income and savings to prepare for temporary unemployment spells; they were probably able
to consumption smooth quite well beforehand. Second, high-income workers are usually
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high-productivity workers; they probably find it relatively easy to find new jobs after becom-
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ing unemployed.
However, the fact that these workers have high productivity suggests another benefit of
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raising the maximum benefit. Insofar as their productivity is specific to a particular type of
job, it may take higher-wage workers a relatively long time to find jobs that are good
matches to their specific skills that lead to higher productivity. Generous unemployment in-
surance benefits would allow these productive workers to take more time to find jobs that

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are better matches—that is, jobs that do not waste their human capital.
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3. Workers’ compensation benefits vary across states and types of injuries. How can
you employ this information to estimate the elasticity of injury with respect to work-
ers’ compensation benefits generosity?
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Suppose that one had state-level data on the injury frequency. One could try to regress
frequency of injuries on the level of workers’ compensation benefits, but it would raise the
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standard “correlation versus causation” problem: one wouldn’t be able to tell whether the

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higher benefit levels caused frequency of injury, or whether there is some other reason for
the relationship (for example, states with more risky industries have more injuries and are
more generous because workers have more political power). Having variation in injury types

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would allow the researcher to include state and injury-type fixed effects in her regression of
benefit level on injury frequency—to account for the possibility that injury reporting behav-

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ior is different in different states and for different injuries. The coefficient on “benefit level”
could then be used to compute an elasticity of injury with respect to benefit level.

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This approach would be better than just looking at across-state variation, but the ap-
proach could still have problems. One would have to worry about the possibility of benefits
being high for some injuries (but not others) in some states because of something particular
to that injury in that state. That is, one might still be worried about state- and injury-specific
things that would lead to both higher workers’ compensation levels for that injury in that

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state and higher injury rates for that injury in that state. A (hypothetical) example: states
with textile industries have many losses of fingers and because of unionization have high

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compensation for finger loss but not for any other types of injuries.

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4. The Organisation for Economic Co-operation and Development (OECD) compares net

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replacement rates for unemployed families of different types across countries. These
data are available online through the “Statistics” link at http://www.oecd.org/els/

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social/workincentives. In which countries has the replacement rate provided by unem-
ployment benefits increased since 1961? Has the replacement rate declined in any
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countries?
Portugal’s gross replacement rate rose from 0% to 43% between 1961 and 2007. Italy,
Finland, Denmark, Switzerland, and Norway also saw dramatic increases in replacement
rates over that time period. Japan’s replacement rate has remained low, falling from 12% to
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8% over that time, and the United Kingdom’s replacement rate has fallen as well, from 24%
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to 12%.
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5. What does the empirical evidence on the consumption-smoothing benefits of unem-

ployment insurance indicate about the degree to which individuals are, on average,
insured against the income losses associated with unemployment?
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Gruber (1997) found that people are not completely insured against unemployment in-
come loss and so are unable to smooth their consumption during periods of unemployment.
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While unemployment insurance reduces the decline in consumption associated with unem-
ployment, it does not allow for full consumption smoothing. In addition, unemployment in-
surance does crowd out other sources of savings and income. Gruber’s study found that
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approximately 30% of unemployment benefits were used to shore up consumption during

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spells of unemployment, but that 70% of the benefits crowded out other sources of consump-
tion smoothing.

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6. Consider Meyer’s (1989) study of the effects of unemployment benefits on unemploy-

ment spell durations. How does this study deal with the likelihood that unemployment
spells and unemployment benefits may both increase during economic recessions?
It seems logical to assume that people will remain unemployed for longer periods of
time during a recession as it is harder to find another job at these times. It also seems logical
to assume that people will remain unemployed longer if their benefits are increased. To dis-
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tinguish between the effect of a recession and the effect of increased benefits, Meyer used
the difference-in-difference approach. Because the increase in benefits was greater for
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higher-wage earners, he compared the difference in unemployment duration among high-

wage earners in a state without the benefit increase (Pennsylvania) with the difference in
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unemployment duration among high-wage earners in New Jersey, where benefits had in-

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creased. The increase in duration in Pennsylvania established the recession effect. The extent
to which unemployment duration was even longer in New Jersey could be attributable to the
higher benefits. However, recessions don’t affect states equally. The industrial mix in a given

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state can make it more or less vulnerable to recessions, so the recession effect in Pennsylva-
nia may not have been exactly the same as the effect in New Jersey. To investigate that pos-

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sibility, Meyers also compared unemployment duration in New Jersey among workers who
did not receive increased benefits (the lower-wage workers) with those whose benefits had

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increased.
7. Gruber (2000) found evidence that the elasticity of labor supply with respect to dis-
ability insurance benefits is considerably smaller than the estimates of the elasticity
of unemployment durations with respect to unemployment insurance benefits. Why

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might moral hazard be less of an issue in the disability insurance program than in the
unemployment insurance program?
For moral hazard to be a significant problem, there must be informational asymmetry

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and the beneficiary must have substantial control over the triggering event (or the duration of

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the event). Several features of the disability insurance program reduce the likelihood of

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moral hazard. Certainly there is informational asymmetry: the claimant has better informa-

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tion about his or her true ability to work. However, the five-month waiting period before

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benefits begin reduces the incentive of the claimant to stretch the truth, and the requirement
that the disability be certified by a state body reduces the informational asymmetry. Because
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disability is often a permanent condition, once it is determined to be legitimate, moral hazard
with respect to duration is not a major factor.
One feature of unemployment insurance in particular makes it susceptible to moral haz-
ard: the requirement that the recipient actively seek employment. This feature is very diffi-
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cult to monitor and enforce. As a result, there is informational asymmetry about the extent to
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which the recipient seeks new employment and an opportunity for the recipient to be less
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than aggressive in a job search. Because the recipient determines the level of effort he ex-
pends in his job search, he has a large degree of control over the duration of the unemploy-
ment spell.
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8. Governments typically provide disability insurance and unemployment insurance to

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workers. In contrast, governments typically mandate that firms provide workers’ com-
pensation insurance to their workers but do not provide the coverage. Why the differ-
ence? Why don’t governments provide workers’ compensation instead of mandating it?
By requiring firms to provide workers’ compensation insurance for their workers, the
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government induces firms to internalize the costs of a risky work environment for their
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workers. A firm with a history of on-the-job injuries will find it extremely expensive to buy
insurance. The firm therefore has an incentive to reduce on-the-job injuries. If the govern-
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ment provided workers’ compensation insurance directly, employers would be less careful in
making sure that their workers were not injured on the job (unless there was perfect experi-
ence rating). In other words, by requiring firms to purchase their own workers’ compensation
insurance, the government reduces moral hazard on the firm side and presumably makes
workplaces substantially safer than if it picked up the tab for firms’ carelessness.
9. In May 2004, the state of Vermont significantly reformed its workers’ compensation
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system. One key provision of this reform was to reduce the window of time during
which a claimant could file an initial workers’ compensation claim. Will this help to re-
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duce the degree of fraudulent use of the workers’ compensation system? Explain.
Limiting the time between an injury and a claim could possibly reduce fraud. As men-
tioned in the text, some of the most difficult injuries to verify are soft-tissue injuries, such as
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muscle strain. The precise moment of injury may be difficult to identify or the injury may be

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the cumulative result of small events or overuse. As a result, it is difficult to determine
whether the injury happened at work or elsewhere. Allowing a worker to wait for a long pe-
riod of time before reporting these kinds of injuries increases the worker’s ability to charac-

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terize a nonwork injury as one that happened on the job. On the other hand, sometimes these
kinds of injuries are not apparent until well after the fact, so this policy change could reduce

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the number of legitimate claims.

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10. Senator Doppelganger has proposed rules that will make it easier for workers to
apply for and receive disability benefits. What is this likely to do to rates of applica-
tion for disability benefits? To the reported unemployment rate?
More people who lose a job or are unemployed for an extended period of time are likely
to apply for (and receive) disability benefits than before, even if they have relatively minor

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injuries. Individuals who are receiving disability benefits are not considered to be looking
for a job—indeed, if they could reasonably find a job, they are not even eligible for disabil-
ity benefits. This rise in disability application and benefit receipts will thus tend to crowd out

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unemployment. Autor and Duggan (2003)1 use a 1984 policy change that eased the receipt of

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disability benefits to argue that disability insurance can cause substantial unemployment

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crowd-out.

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Advanced Questions
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11. Are individuals more likely to maintain their pre-injury consumption levels after an
easily preventable on-the-job injury than after a difficult-to-prevent on-the-job injury?
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Explain.
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The occurrence of an easily preventable injury raises the suspicion of moral hazard. Peo-
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ple who do not have savings or an alternative source of income during a time when they are
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unable to work may be more careful on the job; for them the cost of injury, in terms of re-
duced consumption, is high. Injuries suffered by these individuals are more likely to be ones
that were difficult to prevent. These people will not be as able to maintain pre-injury con-
sumption levels. People who have sufficient savings or other income to smooth consumption
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during out-of-work spells may not be quite as cautious, so they would be more likely to suf-
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fer easily preventable injuries. Once injured, they are also better able to maintain pre-injury
consumption levels.

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leave unemployment earlier (that is, find or take a job sooner) have no higher post-
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unemployment wages than do workers who leave unemployment later. This result
could be interpreted as evidence that the quality of the job match does not improve
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as the unemployment spell grows longer.

a. What does this interpretation of the evidence imply about the moral hazard costs
of unemployment insurance?
Had the evidence indicated that longer unemployment durations led to better job
matches, you might conclude that workers were truly exerting effort to find better matches
during unemployment spells. Those who look longer find better jobs; those who take the
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first offer to come along have shorter spells. The fact that the evidence shows no better
matches for those who take longer suggests that the longer duration was not spent looking
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1Autor,David H. and Mark G. Duggan, “The Rise in the Disability Rolls and the Decline in Unemployment,”
Quarterly Journal of Economics, 2003, 118 (1 February), 157–205.
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for better jobs. The longer unemployment duration may just have been due to moral haz-

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ard: the temptation to not even start to look or to look half-heartedly until the benefit pe-
riod had almost run out. This interpretation suggests that longer benefit periods, by
allowing delays in the job search, increase moral hazard costs.

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b. An alternative explanation for this evidence is that workers with longer unemploy-
ment spells are less qualified than are workers with shorter unemployment spells.

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How could you empirically distinguish between this explanation and the explana-
tion put forth in a?

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The basic “alternative” argument put forth in a is that the well-qualified have an eas-
ier time finding jobs early, while the less-well-qualified take quite a bit longer because
they have fewer good matches. This would mean that people who find jobs early would
tend to have higher wages. Observing that people who get jobs later do not have higher

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wages could simply be a result of two offsetting effects: first, longer searches improve
productivity for any given worker, and second, higher productivity workers tend to take
jobs earlier. To try to rule out this alternative explanation of the data, the perfect approach

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would be to randomly assign some workers to short unemployment insurance durations

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and some workers to long unemployment insurance durations. If the interpretation in a is

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correct, both groups have the same wages when they find jobs, but the long-duration
group would have longer durations. If the alternative explanation is correct, the longer-

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duration group would have both longer durations and higher wages.
13. The U.S. Department of Labor’s Web site, http://workforcesecurity.doleta.gov/
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unemploy/, includes a table of the major differences in unemployment insurance
programs across states (see http://workforcesecurity.doleta.gov/unemploy/pdf/
sigmeasuitaxsys08.pdf). At the time of this writing, the state of Kentucky had a much
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wider range in the payroll tax rates paid by different experience-rated firms than did
Oregon. Which state’s system subsidizes firms with high layoff rates to a greater
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degree? Explain.
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These data suggest that Oregon does not engage in as accurate or refined experience rating
of firms as Kentucky does. Imperfect experience rating means that firms with more frequent
layoffs do not pay the entire cost of the layoffs. In this case, it seems that Oregon subsidizes
high-layoff firms to a greater extent than does Kentucky. In Kentucky, a firm is likely to think
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twice before laying off workers, because when it does its workers’ compensation premium will
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increase. Layoffs are costly to the firm. In Oregon, the number of layoffs necessary to jump
into the next-higher premium bracket must be higher than in Kentucky. (Since there are fewer
total brackets, they must span larger ranges.) As a result, some layoffs are “free” in the sense
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that the firm will not face a higher workers’ compensation premium. The free layoffs generate
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workers who claim the benefit. Someone must be paying the benefits, and it is not the firm.
Thus, the Oregon program subsidizes some firms who lay off workers.
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14. You are hired by the presidential administration to review the unemployment insur-
ance (UI) program, which currently replaces approximately 45% of a worker’s wages
for 26 weeks after she loses her job.
Consider two alternative reforms of the current UI system. The first is to experi-
ence rate firms fully, so that the taxes firms pay are set exactly equal to the benefits
their workers receive (benefits remain at 45% of wages). The second is a system of in-
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dividual full experience rating—the government would loan individuals 45% of their
wages while unemployed, but they would have to pay this back when they get new
jobs.
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a. Contrast the effects of these alternative policies on unemployment durations and

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the likelihood of worker layoffs.
Perfect experience rating would put an end to the subsidization of the layoff/rehire
pattern of some firms and thus would certainly reduce layoffs. This reduction could lead

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to increased unemployment duration, though. Perfect experience rating would probably
shut down firms that are just on the margin of staying in business or firms with seasonal
production. Under the current system, these firms can lay off and rehire quickly without

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bearing the full cost. Firms can retain the loyalty of their laid-off workers during slow

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times by allowing the government to subsidize their downtime and then rehire them as
needed. Under the new proposal, firms that have seasonal operations or that need to close
plants temporarily will face increased costs in the form of increased unemployment insur-
ance premiums. If these costs force the firms out of business, their former employees will
have to find new work, something that may take longer than just waiting for a callback

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from their old employers. Even if the firms did not go out of business, they might wait
longer to call back former employees. With perfect experience rating, it may be cheaper

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for firms to lay off workers less frequently but for longer periods of time. In particular, a

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layoff of longer than 26 weeks would be cheaper for firms than two shorter layoff periods

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because the firms would not bear the cost of the 27th and later weeks.

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The individual loan system completely shifts the burden of unemployment from the
firms to the individual. If firms bear no cost associated with unemployment, they may be

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more willing to lay off (and hire) workers. Under a system of partial experience rating,
firms have at least some incentive to keep workers on over short periods of slow produc-
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tion. Without this incentive, firms may lay off workers much faster at the beginning of a
downturn. On the other hand, because the benefit is in the form of a loan, workers have
substantial incentive to seek new employment as soon as possible, so the duration of unem-
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ployment should fall. Under this system, firms that are particularly seasonal or cyclical
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would suffer. They would be less able to hire back their original workers because the work-
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ers would have sought work elsewhere (either to reduce the time of the loan period or be-
cause they wanted more stable employment to avoid having to take loans in the future).
b. What are the consumption-smoothing properties of each alternative policy?
By reducing the number of cyclical and seasonal layoffs, the firm-level experience-
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rating system would tend to smooth consumption. However, the extent to which the sys-
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tem increased unemployment duration would undermine the consumption-smoothing

benefits. Long unemployment spells are more difficult for a worker to smooth over. After
26 weeks, no benefits would be paid, and by that time any savings might have been de-
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pleted as well. The firm-level experience-rating system might enhance short-term con-
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sumption smoothing, but it would worsen long-term consumption smoothing.

The individual loan system could either help to smooth consumption or hurt consump-
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tion smoothing. On the one hand, by providing access to credit during the time of unem-
ployment allows workers to transfer income from later (after they find a job) to their
periods of unemployment. It therefore smoothes consumption across the unemployed and
re-employed periods. On the other hand, it makes it more costly for a worker who has re-
cently become unemployed to consume, since they know they will have to pay back the
loan eventually. This means that they may choose to consume less after becoming unem-
ployed than if they received cash benefits instead of loans. If so, there could be a larger
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drop-off in consumption after they become unemployed—less smoothing. (This effect

would be at least partially offset by increasing saving prior to becoming unemployed.)
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ote: The icon indicates a question that requires students to apply the empirical economics
principles discussed in Chapter 3 and the Empirical Evidence boxes.
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