WE - ALL except Pensions & week 4

Can we leave Disability Insurance to the market?

1) Independent risks = yes
2) P <1 = yes
3) P known or estimable = yes
4) no adverse selection = NO
5) no moral hazard = NO

Why do we need state intervention in Disability Insurance

1) moral hazard & adverse selection
2) Redistribution

Adverse selection and Disability insurance

asymmetric information = insurance very expensive for individual with bad health (underinsurance when good health)

Dealing with adverse selection in disability insurance

mandatory insurance

Moral hazard and Disability Insurance - Three sides

1) insured worker
2) employer
3) medical doctors

Moral Hazard DI - insured worker

may invest too little in their health, take too many risks, or try to exaggerate their impairments

Moral hazard DI - employer

may invest too little in prevention and reintegration, or try to use DI as substitute pathway into unemployment

Moral Hazard DI - medical doctors

may take into account personal condition of workers (third-party payment problem)

Disability Insurance in Practice

1) public provision
2) strong regulation
3) possibility to buy complementary insurance from a private insurer

Trade-off when designing Disability insurance

disincentives effects on labor supply
VS
providing adequate insurance against income loss

DI - disincentives effects on labor supply

price of insurance, how much does it cost to increase coverage, also in terms of labor supply

DI - providing adequate insurance against income loss

Value of insurance
depends on risk aversion and distributive preferences

Disability insurance provides coverage against

loss of earnings due to
1) professional risks
2) social risks

DI - professional risks

disability caused by work

DI - Coverage against professional risk

1) mandatory insurance
2) risks are defined rather precisely
3) provision of insurance can be private

DI - Coverage against social risks

benefit level typically related to work history

Different ways to organise DI programmes

1) Flat-rate benefits
2) Unemployment-type benefits
3) Pension-type benefits

DI - Flat-rate benefits

benefit level similar for everyone
= tax-financed

DI - Unemployment-type benefits

benefits depend on recent work history (as in unemployment insurance), replace a portion of previous earnings

DI - Pension type earnings

benefits dependent on entire work history

Residual earnings capacity (formula)

disability degree = ( Earning before MINUS earnings after ) / earning before

Insurance eligibility

often determined by threshold for earnings capacity

threshold for earnings capacity

1) either minimum percentage loss of pre-disability earnings
2) or maximum absolute level of residual earnings

Working when getting disability benefit

benefits get less, the more you work
partial benefit or reduced entitlement

Disability insurance and work incentives

1) Fixed benefit
2) Income replacement
3) wage subsidy

DI - Fixed benefit

benefits do not depend on hours/earning of the recipient (up to a threshold)

DI - rational behind Fixed benefit

fulfill basic needs + compensate for additional cost of working with disability

Effect of Fixed benefit on labor supply

Income effect = less working hours

DI Fixed benefit & budget constraint

shifts budget constraint upwards
= Income effect purely

DI - Income replacement

benefits cover percentage of lost earnings

DI - Rationale behind Income replacement

1) maximal benefits if person unable to work
2) no benefits needed if earnings do not drop

DI - Effect of Income replacement on labor supply

Substitution AND Income effect

DI - Effect of Income replacement on working hours

decreases working hours

DI - Effect of Income replacement on budget constraint

turns budget constraint upwards
same starting point but less steep now

DI - Income effect of income replacement

intersection of upwards shifting old budget constraint and higher indifference curve

DI - Substitution effect of income replacement

from intersection of old budget constraint slope and new indifference curve TO tangent point of higher indifference curve and new budget constraint

DI - Wage subsidy

Get higher benefits if work more than a given threshold

DI - Rationale behind wage subsidy

Alleviate some of the undesirable effects of the flat benefit, stimulate labor supply

DI - Wage subsidy effect on working hours

depends where the threshold is

DI - Wage subsidy effect on budget constraint

has a jump at the threshold

DI - Wage subsidy effect when threshold is above optimum (e.g. less hours than optimum)

will work less hours at higher indifference curve

DI - Wage Subsidy effect when threshold is below optimum (more hours than optimum)

more hours worked at higher indifference curve

Trade-offs for optimal coverage of DI

1) reduction in labor supply due to moral hazard or due to alleviating liquidity constraints
2) costs of disincentives vs value of insurance

Moral hazard as reason for less employment when DI is generous

people enjoy leisure that is paid for by the insurance
= without DI they would work

Liquidity constraints as reason for less employment when DI is generous

DI allows people to take time for health they wouldn’t otherwise

How to determine if its moral hazard or liquidity constraints

compare incentive effects for individuals with more or less liquidity constraints

DI - Same incentives effects across individuals (with more or less liquidity constraint)

moral hazard as reason for less employment

DI - stronger effect for liquidity constraint group

liquidity constraint plays a role in less employment

Optimal coverage of DI

optimal drop in consumption = incentive effect of DI / risk aversion

Incentive effect of DI - Type of question

what is the influence of the DI system on unemployment duration
= empirical question

Categories of DI reforms

1) Enhancing employer incentives
2) Stricter screening
3) Increasing work incentives

DI - Enhancing employer incentives

1) continued wage payments
2) DI experience rating

Pros - Enhancing employer incentives

1) reduces DI inflow
2) decreases DI outflow

Cons- Enhancing employer incentives

1) too much risks imposed on firms
2) adverse effects on hiring

Enhancing employer incentives - adverse effects on hiring

1) Overall effect in employment ambiguous

2) Related: more temporary hirings for disabled workers

DI - Stricter Screening pros

immediate impact on DI inflow
= less ill apply less
= higher rates of returns for workers
= spill over unto unemployment insurance

DI - Stricter Screening cons

negative effects for different groups (women)

DI - Increasing work incentives - pro

stimulating people to work can have beneficial effects

DI - Increasing work incentives con

risk of long term adverse consequences
1) deter people who actually need it
2) need to work more than is good for their health

Option to re-integrate disabled workers in the labor market

1) ALMP
2) Quota

ALMP for Disabled workers

subsidised employment

Aim of ALMP for disabled workers

1) bridge productivity gap
2) internalize positive externalities of hiring disabled workers
3) satisfy equity concerns

Quota for workers with disabilities

firms have higher share of disabled employees but partly through labelling disabled workers and reallocation among firms

Textbook economics def. Income effects

change in demand for a good given a change in income

Textbook economics def. Substitution effect

change in demand for a good given a change in the relative price of that good

Income effect in the context of DI

reduction in labor supply due to benefit recipient
= extra income can be used to alleviate strains of work

Income effect in the context of DI - Budget line

upwards shift

Substitution effect in the context of DI

reduction in labor supply due to lower marginal gains of working
= claw-back effect

Substitution effect in the context of DI - Budget line

change in the slope of the budget line

Budget line changes for income exemption

up to threshold budget line slopes does not change, then slope becomes flatter

Why may an income exemption not increase working hours?

1) strong preference for leisure (high strain from work)
2) many individuals already have income from work
3) no small jobs available
4) fear of medical re-assessment may persist

Optimal working hours when there is a work subsidy when working more than certain amount of hours

= jump in benefits at threshold
= two budget constraints
= calculate utility for each
= compare

Are benefits at the optimal level? (formula)

risk aversion * drop in consumption = elasticity of time receiving benefits wrt to benefits

Reason for compulsory disability insurance for self-employed

1) internalising social cost
2) consumption smoothing (avoid shocks to consumption)
3) mandatory insurance to avoid adverse selection

Advantages of compulsory disability insurance for self-employed

1) avoid gaps (adverse selection)
2) fewer costs for tax payers

Disadvantages of compulsory disability insurance for self-employed

1) financial burden for freelancers
2) limited coverage
3) long waiting lists?

compulsory disability insurance for self-employed - Who might be for and who against?

Pro = labor unions, sick freelancers, taxpayers
Con= healthy freelancers

Def. Marginal tax rate

the percentage of tax you pay on your next euro of income earned

Def. Average tax rate

total tax paid divided by your total taxable income

How to define marginal tax rate? (formula)

Income tax + taper rate

Def. taper rate

decrease in benefits after an increase in income

Kind of traps

1) poverty trap
2) unemployment trap

Poverty trap

no financial incentive to work longer hours

Unemployment trap

no/little financial incentive to seek work

Def. taper rates

the rate at which an income-tested benefit (aimed at reducing poverty) is withdrawn as earnings rise

Taper rate & poverty trap

low-income families cannot raise their net income significantly

Effects of high marginal tax rates

1) substitution effect
2) income effect

Substitution effect

labour-supply disincentive

Key takeaway from Taper rates

the more benefits are introduced, the greater the variation in taper rates, greater complexities when different benefits interact

Individuals least likely to increase their working hours?

those who are right at the cut off of not receiving/receiving less

Why does the marginal tax rate decrease at the top?

Because at a certain point you are not eligible for any benefits = no benefits to decrease

Credit and Marginal tax rate

incentive device
= reduce the MTR and targeted at low income households to increase their labor supply

(work) Credit and tax load

reduces someone’s taxable income = reduces taxes to be paid

Pressure on Marginal tax rate

1) upwards when benefits are decreasing as income rises
2) downwards when benefits are increasing (lighten the tax burden) when income is low

Key trade off for marginal tax rate

targeting vs incentives (leakage and gaps)

Marginal Tax rate and targeting

to reduce leakages
= benefits decrease in order to ensure that rich people to not get any benefits

Taper effect

marginal tax rates increasing in income = reduces incentives to work

Paradox of Marginal Tax Rate

benefits reduce your taxable income = marginal tax rate is higher
= incentive to work is lower = moral hazard

Moral hazard effect of marginal tax rate

stronger incentive to remain on welfare benefits

Marginal Tax rate - bunching

mass of people at a specific point caused by behaviour effects