Rethinking unemployment insurance: Part I

With 2.7 million more Americans unemployed compared with the start of the year, unemployment insurance has returned to the forefront as a public policy issue. Most of the talk has been about extending unemployment benefits. It may be time, though, for lawmakers to engage in a more comprehensive reform debate – one that includes a proposal by Jeff Kling to alter the structure of unemployment insurance in such a way that recognizes the psychology of losing a job and strengthens the incentives for returning to work.

Kling’s revenue-neutral proposal would reform unemployment insurance by shifting government resources toward protection against especially damaging long stretches of unemployment or permanent effects of job loss, such as lifetime wage reductions. Laid-off workers can remain unemployed for long stretches for two major reasons, one economic and one psychological. 1) They simply cannot find work; 2) They refuse to take lower paying jobs thinking they can find a new one that pays as much as their last.

To create an incentive for workers to clear the psychological hurdle, Kling proposes setting up temporary earnings replacement accounts (TERA) to improve the protection against the effects of long-term unemployment and permanent wage-reduction. The account would be funded by the workers themselves during more prosperous times, and drawn from during periods of distress. Workers could also borrow against the account from future earnings. During periods of unemployment or lower-wage jobs, workers would draw funds from both their unemployment account and more traditional unemployment insurance (UI), which would result in a broader safety net from a similar government budget. While the unemployment accounts would be funded by workers, the unemployment insurance would be funded by firms, as it is currently.

In comparison with UI, use of TERAs should reduce the average amount of time that people spend out of work. Use of TERAs instead of UI increases the price for additional unemployment (at least among those who do not expect to retire with an unpaid loan), because TERA withdrawals would need to be repaid from future income. As a result, the introduction of TERAs may reduce the overall duration of unemployment by 5 to 10 percent.

The duration of unemployment would also be affected by the availability of wage-loss insurance. Individuals considering a job offering a wage below their insured wage level would be more likely to accept it, since the hourly rate of pay would be augmented by wage loss insurance payments. Making work more rewarding should reduce the tendency of some people to become discouraged and to remain unemployed or even stop looking for work. This reduced duration of unemployment is unlikely to be associated with workers taking jobs too rapidly, rather than waiting more patiently for a more productive job match.

Kling’s proposal could also reduce layoffs by firms, which will be explained further in the next post.

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