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Unemployment benefits – After all are perverse incentives that relevant?

“Everyone agrees that really generous unemployment benefits can raise the normal unemployment rate… But in case you haven’t noticed  what’s limiting employment now is lack of demand. Their incentives to seek work are, for now, irrelevant.”

Paul Krugman

Unemployment has been growing during the last years. Since 2007, OECD countries unemployment rate has increased over 2% to 7.9% in 2013. The situation is even more serious in the Euro Area with countries such as Greece or Spain with huge unemployment rates (27.3% and 26.1% respectively). Along with unemployment, and even considering that some governments are reducing the amount of benefits paid per individual, the total social protection expenditure has been increasing in most countries.

However, the crisis has forced governments to control their deficits. Therefore some have reduced unemployment benefits, claiming financial restrictions and perverse incentives. I would like to discuss the role of perverse incentives in unemployment benefits.

Let’s begin by assuming an extreme situation in which Mr. Smith is unemployed and he will receive a benefit which is equal to his previous wage. Moreover, let’s assume there are no constraints related with the duration of that benefit. Given this example, economic theory states that, in fact, the unemployment benefit that Mr. Smith receives will reduce his incentive to go back to work. If he is receiving the same than before without having to work, then he is actually better off than before!

Although this example is an extreme case it’s useful to understand that economists have some reason when claiming benefits promote unemployment. In fact there is empirical evidence that shows that in weeks prior to the end of the benefit the number of people going back to work increases.

However it is also important to take into account two other factors. The first one is that governments already take that in consideration when designing unemployment programs. Secondly, it’s important to account for the economy downturn in recent years and its effects on job opportunities.

About the first topic, most countries benefits programs already impose restrictions on the value and length of the benefit based on previous labor experience or households composition. It is also common to reduce benefits over time, as well as to have training programs and benefits for employers who hire long-term unemployed individuals. Therefore, current unemployment programs already minimize Mr. Smith’s perverse incentives.

The second topic is also very important, currently lots of people who are unemployed, in developed economies which are facing a crisis, don’t go back to work simply because there is no work for them. The economic crisis has lead demand to contract severely. With few demand for goods and services, companies do not seek as many workers as before. This means that economic crisis and adjustments have destroyed a lot of jobs in several countries and sectors. Therefore, Mr. Smith may remain unemployed simply because he has no choice.

Although several efforts made by governments, some perverse incentives do exist. Still, in a crisis scenario, those incentives are not that relevant because there are no opportunities for unemployed persons. It’s not the right time to deal with those incentives; it’s time to focus on stimulating the economy.

Eduardo Costa

Economics 689

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Author: studentnovasbe

Master student in Nova Sbe

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