Chapter 12: Public Pensions

Historically, the elderly had their needs provided for by their families, however in modern society this has changed, and elderly care has fallen on society

Retirement income is broken into 3 categories:Old Age Security Program ($29 billion in 05-06,

financed out of government revenue)Pension Plans ($32.8 billion in 05-06, financed by

payroll taxes on employees and employers)RPP and RRSP ($57.7 billion, covered in

Economics of Taxation)

Chapter 12: Public Pensions

Why Public PensionsEffects of Public PensionsOld Age Security ProgramCanada Pension PlanConclusion

Why Public PensionsThe justification for publicly provided retirement

income include the “usual suspects”:PaternalismRedistribution Adverse selection

As well as pension-specific justifications:The Samaritan’s dilemma

PaternalismThe government pay provide public retirement

income due to a sense of paternalism arising from 2 sources:

1)People who don’t plan for the future (due to nearsightedness or high discount factors)

2)People who inaccurately plan for the future (not considering future costs or inflation)

One may still ask if it is right for the government to force saving for old age

RedistributionOld Age Security Program has redistributive elements

because:

1)It is funded out of taxes, which are redistributive

2)Old Age Pension has a clawback

3)The Guaranteed Income Supplement is a NIT This setup is preferable to welfare because:

1)The elderly have unique characteristics which are best met by a unique plan

2)Income support through a “pension” is less stigmatic than collecting welfare

3)Intergenerational redistribution is allowed for (if one generation is in a recession and the next is well off)

The Samaritan’s DilemmaSociety wants to take care of the elderly, BUT, if

a young person knows he will be taken care, of, he has an incentive NOT to save for the future.

The Canada Pension Plan, RPP, and RRSP portion of Retirement Income, through required payroll contributions, forces individuals to work towards their retirement income somewhat.

Perhaps the Old Age Security Program still suffers slightly from this attitude

1976-1991 Monthly Labor Force Flows, in 1000’s.

Unemployment in Canada

Labour force participation rate – labour force as a percentage of working age populationAverage 64.8% between 1976-1991

Employment rate – employment as a percentage of working age populationAverage 59% between 1976-1991

Unemployment rate – unemployment as a percentage OF LABOR FORCE

-Note that discouraged workers are not considered to be in the labor force

Unemployment in Canada

Unemployment depends on:People who lose their jobs and look for a new

onePeople who find jobsUnemployed who drop out of labor force

(discouraged workers, students, homemakers)People who enter labour force and look for

work

“TRUE” UNEMPLOYMENT?

Should discouraged workers be considered?Are some unemployed actually looking for

work?How do we take workers who want more hours

into account? (partially unemployed)There are even difficulties in definition

Labour Market T

rends

Labour Market TrendsLabour participation and employment rate has

increased, due to dramatic increase in participation rate of married females

These rates have fluctuated with the economy and the unemployment rate

Unemployment Trends

-Canadian unemployment has increased since the 1950’s (4.2%)

-This unemployment has been decreasing since 1995

-Note the US-Can gap

Provincial Unemployment

-Note that duration of unemployment can be as significant than unemployment rate

Demographic Unemployment

Unemployment notes-in 2005, percentage of unemployed that

remained unemployed for a year are:

Canada: 9.6% US: 11.8%

France: 42.5% Germany: 54%

-Men had higher unemployment, but for a shorter time

-Younger people have higher unemployment

-Less education is correlated with higher unemployment

Why Employment Insurance?Two key reasons lie behind government provision

of employment insurance:

1)Market Failure (moral hazard, adverse selection, economic cycles)

2)Income Redistribution

Market Failure – Adverse SelectionSome people (young males without high

school) have higher unemployment and therefore higher demand for employment insurance

This results in high premiums…Which results in unappealing insurance for low

risk individuals…Which raises premiums even higher

Government insurance avoids adverse selection by offering premiums based on AVERAGE expected loss to EVERYONE

Market Failure – Moral HazardEmployers can fire their workers, deciding

whether they use employment insuranceUnemployed can lengthen their unemployment

time, affecting the amount of EI they receive

Government insurance can’t eliminate Moral Hazard, but it limits it through:

Offering no EI for the first few weeks of unemployment

Only paying a portion of employed earningsSimilar to a deductible in typical insurance

Market Failure – Econ. CyclesDuring a recession, employment insurance

claims riseDuring an expansion, employment insurance

claims fall

The government is better equipped to borrow and save to weather these movement

EI and Income RedistributionEI naturally redistributes wealth from those who

don’t suffer employment loss to those who doSince some people have claims more often and

longer claims, there is even more redistribution

IS Employment Insurance good as an income redistribution program?There are those who agree…(next slide)There are those who disagree…(2 slides hence)

EI and Income Redistribution YESEmployment Insurance supplements social

assistancePeople receiving EI may not need welfare programs

Some argue that Employment Insurance has less of a work disincentive than typical welfareThere is no implicit tax rate on earningsEI requires a certain level of work, and therefore is

similar to “workfare” (Osberg, 1995)

EI helps those who normally have employment while social assistance helps those who have limited ability to be self-supporting

EI and Income Redistribution NOEmployment Insurance does a poor job of

redistributing income to the poorPeople in equal positions are not treated equally

(horizontal equity)Tax burdens are not distributed fairly across people

with different abilities to pay (vertical equity)

Employment Insurance causes major labour market distortions (firms and workers)

EI History – 1930’s1933 – 25% unemployment, 15% “on relief”

“On relief” largely covered by provincial and municipal governments

1935 social insurance program ruled ultra vires; outside the federal government’s jurisdiction

1867 Constitution Act amended (by federal and provincial governments) to allow for federal unemployment insurance

EI History –1940’s and 1950’s1940 Unemployment Insurance Act

Covered jobs with MODERATE risk of unemployment (not high or low risk) 42% of labour force

50% of wage benefits, plus 15% if marriedlasting for 1/5 of days worked in last 5 years, minus

1/3 of days already claimed in last 3 years

1950’s – UI extended to seasonal workers and “self-employed” fishermen

EI History –1971 Reforms1971 Unemployment Insurance Act (Bill C-229)

Covered 93% of labor force (including self-employed)

Minimum eligibility – 8 weeks of workBenefit 66% of wage, 75% with dependents

Had a maximum insurable earnings levelSickness and maternity benefits increasedDuration linked to weeks worked in qualifying period

Increased when national unemployment exeeded 4%Increased when regional unemployment exceeded

national by 1-3% (regional extended benefits)

EI History –1971 Reform ImpactUnemployment was constant between 1971

and 1972, yet:People covered: 5.4 million to 7.8 millionWeeks of benefits: 22.6 million to 30.5 millionAverage weekly payment: $40.28 to $61.79Expenditure more than tripled:

$0.59 billion to $1.87 billion

Expenditure rose from 0.8% of GNP in 1971 to 2.1% in 1975

EI History –1975 ReformsThose who quit or were fired from misconduct

couldn’t claim for 6 weeks (up from 3)Age limit reduced to 65 years (from 70)75% dependent coverage eliminated (all 66%)

Increased benefits became linked to an 8 year moving average, instead of 4% trigger

EI History –1977 ReformsNew entrants, re-entrants to labor force and

people with repeated claims needed more weeks of employment to qualifyExemptions for repeat claimants in high-

unemployment regions

Benefits reduced to 60% of wage (from 66%)High income earners clawed back at 30% in net

income was 1.5 times maximum insurable earnings

EI History –1980’sUnemployment went from 7.6% (1981) to

11.9% (1983)Benefits rose from $4.76 billion to $10.1 billionMacdonald Royal Commission on the

Economic Union and Development Prospects for Canada (1985) concluded:UI increased unemployment rates since 1971Income redistribution should be replaced by a NIT

The commission was opposed by Altantic Canada and labor movement and was never adopted

EI History –1980’s1989 Bill C-21 did some changes:

UI funds could be used for training, relocation assistance, and other employment measures

This was meant to fight long-term unemploymentRepeat users no longer had different qualification

provisionsUI became entirely funded by employer and

employee contributions (no general fund government funding) (as of 1991-1992)

EI History –1990’sUnemployment rose to 11.3%, causing an UI

deficitGovernment increased employee and employer

contributionsThis may have lead to more lay-offs

1993 benefits reduced to 57% (from 60%)Those who quit without just cause became ineligible

for UI benefits

EI History –1990’s1994 – UI eligibility in high unemployment

regions increased to 12 weeks (from 10)20 weeks was required in other regions

Benefits could last from 17 to 50 weeks depending on weeks worked and regional unemployment

Benefit reduced to 55% (from 57%)But raised to 60% for low-income recipients with

dependents

Employee contributions increased again

EI History –1996 Reforms1996 Employment Insurance Act eligibility:

Eligibility based on HOURS of last 52 weeks420-700, depending on unemployment rate910 hours for new entrants to labor force and

those entering after 2 years600 hours for sickness, maternity, or parental

benefitsFishing benefits depend on earnings in a fishing

season ($2500 to $4200 depending on regional unemployment)

This change took part time work and seasonal work into account much better

EI History –1996 Reforms Benefits55% of insurable earnings, to a maximum of

$39,000 (reduced from $42,380)This has held constant, allowing a maximum $413

payment per weekLow-income claimants with children can get a

Family Supplement to increase their benefits to 80% (family income less than $25,921)

Incomes exceeding $48,750 repay 30% of benefits2 week waiting periodCoverage time depends on hours of work and

regional unemployment rate Week limits for maternity, sickness, and paternal

Labour Market Effects of EIMoral Hazard problems exist if:

a) An insured individual can affect the probability and magnitude of a loss and

b) This changing behaviour is unobservableMoral Hazard doesn’t focus on those who

abuse and cheat the systemMoral Hazard can apply to both employers and

employees

Labour Market Effects of EISome studies (Grubel et al. 1975) found that an

increase in EI generosity increased the unemployment rate

But other studies (Corak 1994) found no aggregate effect (but he allowed for non-aggregate effects)

Other factors affect the unemployment rate aside from EI

Labour Market Effects of EIThe labour market effects of the Canadian

Employment Insurance System can be divied into:

1)Direct Effects (layoffs, quits, duration of employment, labour force participation)

2)Systemic Effects (industrial mix, labour mobility, education)

3)Macroeconomic Effects (automatic stabilizing effects)

Direct EffectsUnemployment is caused by:

1)Seasonal variations in demand

2)Business cycle fluctuations in demand

3)Long term trends in the economy

EI is aimed at the second cause. Seasonal layoffs are predictable and therefore

not an insurance riskTrends require retraining or moving, not

temporary income replacement

Direct Effects - LayoffsFrom 1980 to 1988,

58% of lost jobs were permanent layoffs 21% temporary layoffs21% quitting (Baker et al, 1996)

When a firm needs to cut costs, including labour, it can reduce hours or lay offWith EI, laying (which has EI support) off is more

attractive than reducing hours (which has no EI support)

Therefore EI encourages layoffs

Some firms (incl. gov.) may design job length according to minimum EI work requirements

Direct Effects - QuitsPrior to 1993, workers who quit got UI in

Canada but not the states, resulting in:Equal job quitting in Canada and the US20.6 weeks average unemployment in Canada11.2 weeks average unemployment in US

(Baker et al, 1996)

If EI applies to quitters, the unemployment rate is increased by longer job searches

Direct Effects – Unemployment Duration

Better EI benefits can lengthen the time people spend looking for “the perfect job”This increases the unemployment rate

BUTThis extra time spent searching can lead to a

better fitThis leads to better labour market performanceThis leads to lower job turnoverThis decreases the unemployment rate

Direct Effects – Labor Force Participation

All workers pay the same EI premiums, but marginal workers who are often unemployed benefit moreTherefore marginal workers are encouraged to join

the labour force by better EI benefitsIf the number of jobs is constant, this increases

unemployment

Sharis and Kuch (1978) found EI increased the labor force, especially among married females

Systemic Effects– Industrial Mix

EI Premiums vary with wageThis relationship doesn’t vary among industries

Premiums are NOT based on expected EI benefits or layoff likelihoodThis does vary among industries

This causes seasonal jobs and small firms to gain more benefits that they pay in

EI therefore subsidizes seasonal and volatile work by taxing stable employment

(See table in future slide)

Benefit-Tax Ratios 2004

High=More Benefits than Premiums

Systemic Effects– Labor Mobility

EI provides greater support to industries and provinces with higher unemployment rates

EI gives Unemployed workers the support to move to a lower-unemployment area and find a job, increasing labor mobility

BUTEI also DECREASES the income gain from

moving, decreasing labor mobilityStudies are inconclusive, plus 70% of people

change provinces for non-work reasons

Benefit-Tax Ratios 2004

High=More Benefits than Premiums

Systemic Effects– Education

If EI is generous, there is a greater opportunity cost to stay in school instead of entering the workforce (especially in seasonal industries)

In the 1970’s many young people in rural Atlantic Canada chose a “pogey”/Employment Insurance lifestyle over education

Yet in 1991, a greater percentage of young people in Atlantic Canada attended university than the national average.

Macroeconomic Effects –Automatic Stabilization Effects

If EI benefits paid out increase and total premiums decrease in a recession AND

EI premium incomes increase and benefits paid out decrease during a boom THEN

EI acts as an automatic economy stabilizerThis does seem to occur in the recessions of the

early 1980’s and the early 1990’s and the boom of the later 1980’s BUT

EI structure has changed over time (especially increasing premiums and disallowing long-term deficits), reducing this effect

EI Revenue Minus Expenditure

Distributional Effects of Employment Insurance

Like many government programs, EI can have a variety of distributional effects, which can be divided into:

1)Distribution of Benefits

2)Financing

3)Regional Redistribution

4)Experience-Rated Premiums

5)Coverage

Distributional Effects – Distribution of Benefits

In the following slide, we see that individuals with income between $10K and $25k make only 31.6% of the labour force but make up 50.5% of claimantsEI does have redistributed effect

BUT

Higher incomes receive higher benefits (often even after clawbacks)

EI often doesn’t affect lowest-income households (disabled, single parents, part-time workers, etc.)

Distributional Effects – Distribution of Benefits

Distributional Effects – Financing

2006 Premiums are $1.87 for employees and $2.62 for employers (per $100) up to a maximum insurable earnings of $39,000Premiums are effectively a “payroll tax”

Studies show EI burden often falls on the employees (as opposed to employers)

Since very low (don’t work) and very high (many investments) income earners often are less a part of EI, its financing has only limited, imperfect optimal income redistribution

Distributional Effects – Regional Redistribution

EI tends to redistribute income from West to East (Quebec and Atlantic)

EI also therefore redistributes income to primary industries (agriculture, forestry, fishing, and trapping) and construction from other industries

EI violates horizontal equity (equal treatment of equals), since two identical people in different unemployment regions have different minimum work requirements

Distributional Effects – Experience-Rated Premiums

In the US, employers who lay off frequently have higher premiums (similar to auto insurance and high-risk drivers)

In Canada, this would mean higher premiums in industries such as construction,

therefore lower wagesLower premiums other industries, therefore higher

wages

BUTSome low wage jobs have high layoff rates

Distributional Effects – Experience-Rated Premiums

Experience-rated premiums tend to DECREASE unemployment, as firms have a penalty for layoffsHigh layoff industries would contract as low layoff

industries would increase

Unemployment would increase short term as workers move from high to low layoff industries

Quebec and Atlantic Canada have many high layoff industries, and would greatly suffer

Distributional Effects – Coverage (2005 Table)

EI covered 43.4% of unemployedGov. claims EI covers 80% of target; it is not meant to

cover some categories

Employment Insurance Conclusion

EI has Insurance and Income Redistribution characteristics (based on loss and need)

Insurance Characteristics:Only contributors are covered Higher income have higher loses therefore higher

benefits

Income Redistribution CharacteristicsLow-income benefit enhanced through Family

supplementHigh-income benefits are clawed back

Employment Insurance Conclusion

Problem of Insurance and Income RedistributionBalancing two goals may prevent doing either goal

wellPerhaps there should be 2 separate programs?But even 2 separate programs would interact

EI reforms (such as hour-based eligibility) have been improvements, but issues and tensions remain even after over 25 years

Chapter 11 Conclusion

Unemployment has increased since 1950, with fluctuations

Unemployment insurance has been essential, but often seen as increasing unemploymentEI affects unemployment through impact on

layoffs, quits, employment duration, labor force participation, industrial mix, labor mobility, education, and automatic stabilization

EI is a government program due to insurance failure due to market failure and adverse selection

Chapter 11 Conclusion

EI has many income distribution effects:Transfers to primary industries and

constructionTransfers to Quebec and Atlantic Canada

In 1996, EI eligibility changed to hour-based

Changes over time have improved EI, but the tension between insurance and income redistribution remains