Welfare compensation for unemployment in the Great Recession

New research by Mariña Fernandez Salgado (University of Essex); Francesco Figari (University of Insubria and ISER University of Essex); Holly Sutherland, Alberto Tumino (ISER University of Essex) analyses the extent to which tax-benefit systems provide an automatic stabilisation of income for those who became unemployed at the onset of the Great Recession.1

The focus of the analysis is on the compensation for earnings lost due to unemployment which is chan-nelled through the welfare systems to this group of people who are clearly vulnerable to the recession’s adverse effects. In order to assess the impact of unemployment on household income, counterfactual scenarios are simulated by using EUROMOD, the EU-wide microsimulation model, based on EU-SILC data integrated with information from the EU-LFS data. The study provides evidence on the differing degrees of relative and absolute resilience of the household incomes of the new unemployed. The consequences of the crisis on the most vulnerable individuals depend on their individual characteristics and the interaction between their labour market participation, their living arrangements and the capacity of the tax and benefit systems to absorb macro-economic shocks.

The paper focuses on a set of six countries of the European Union: Belgium, Estonia, Spain, Italy, the Netherlands, and the UK. These countries experienced different macroeconomic changes during the first phase of Great Recession, with large unemployment increases in Estonia, Spain and the UK (the latter two countries accounting for most of the increase in unemployment at EU level between 2008 and 2009) and relatively moderate increases in Belgium, Italy and the Netherlands. Moreover, these countries have different unemployment protection schemes (and, generally, welfare systems), ranging from a flat scheme in the UK to generous earnings related schemes in Belgium, Spain, and the Netherlands.

Analysis of the automatic income stabilisation effect across European countries focuses on both relative and absolute resilience provided by Net Replacement Rate which is the ratio between household disposable income after and before the unemployment shock. Moreover, in order to measure the extent of protection offered by public support, they introduce a new indicator, namely the Compensation Rate which measures the proportion of net earnings lost due to unemployment, compensated by public transfers net of taxes.
This new indicator isolates net public support from the effect of other earnings present in the household of a new unemployed individual, which usually play an important role in determining the income after the unemployment shock. The compensation rate gives a direct indication of the net public contribution as proportion of the net market income lost due to the unemployment shock.

In order to test whether the income stabilisation offered by the tax-benefit systems prevents the new unemployed from falling below an absolute income threshold, the researchers compare the equivalised disposable income before and after the unemployment shock to the poverty threshold at 60 per cent of the median in the pre-shock baseline. In this way they distinguish the new unemployed who are poor already before the unemployment shock (‘Poor in work’), those falling below the threshold as a result of the shock (‘At risk’) and those remaining above it in spite of the shock (‘Protected’).

Main results

Net Replacement Rate
In the short term, the household income of those entitled to unemployment benefits on average falls to as much as 81 per cent of its pre-unemployment level in Belgium and the corresponding figures are also relatively high in Spain (77 per cent) and the Netherlands (72 per cent). The average Net Replacement Rate is lower, around 65 per cent, in Estonia and Italy, while in the UK it is just 57 per cent. (see Table 1).

Individuals entitled to unemployment benefits face the highest average level of protection in countries characterised by generous and long lasting earnings-related unemployment benefits like Belgium, Spain, and the Netherlands. At the other extreme, in the UK the flat rate Unemployment Benefit payable for at most 6 months offers the lowest level of replacement rate.

As expected, in the long term when the entitlement to unemployment benefits is exhausted for all new unemployed, household income falls much more consistently within a range between 40 per cent (Italy) and 57 per cent (UK) of its pre-unemployment level. Interestingly, in this scenario the country with the highest Net Replacement Rate is the UK with an average value equal to that for those entitled to unemployment benefits in the short term. The UK Net Replacement Rate is also highest in the long term for the sub-group of new unemployed who live in households with no other people with earnings. These are the likely to
be among the new unemployed to experience large reductions in income and low incomes in the long term. In all countries the Net Replacement Rate is lower for this subgroup than for the new unemployed as a whole, strikingly so for Italy.

As shown in Figure 1, a substantial part of the cushioning effect on household income is attributable to the market incomes of other household members and to public transfers (i.e. mainly pensions, in all countries but the UK) which are not primarily designed as automatic stabilisers or as protective safety nets in case of an unemployment shock. Moreover, given that earnings of other household members are progressively more important as household income increases, the average Net Replacement Rates are likely to be pushed up by the presence of these incomes at the top of the income distribution and this is only partly
compensated by progressive income tax.

Considering entitlement to unemployment benefits, it emerges that these play a large role in Belgium (63 per cent of post-unemployment household income), the Netherlands (67 per cent) and Spain (55 per cent). In Italy and Estonia they make up around 40 per cent of post-unemployment household income. In the UK the contributory Unemployment Benefit contributes only 11 per cent of the post-unemployment income while Social Assistance makes up 24 per cent of it. The general lesson of this analysis is that it is necessary to look at the social protection system as a whole and how it interacts with household composition and incomes received by other household members. Focusing exclusively on unemployment benefits is not sufficient.

Compensation rate
In the short term the average net public contribution to the disposable income as proportion of the net earning lost due to unemployment ranges from 40 per cent in Estonia to 74 per cent in Belgium for those entitled to unemployment benefits and from 2 per cent in Italy to 26 per cent in the UK for those not entitled (see Table 2). As expected, the average Compensation Rate is usually much lower for those not entitled to unemployment benefits than for those entitled, with two extreme situations that are of interest. First, the lowest value is achieved in Italy where the Compensation Rate is close to zero given the absence
of general Social Assistance schemes and the only source of income support being channelled through limited family family based tax concessions, which are inversely related to the income of the main earner. Secondly, the highest value is observed in the UK where the Compensation Rate for those not entitled to unemployment benefits is very similar to that faced by those entitled to unemployment benefits. This illustrates how the British contributory Unemployment Benefit does not offer protection that is as generous as in other countries and at the same time, the level of protection offered by the Social Assistance benefits is on average greater than in other countries (assuming full take-up).

Figure 1. Decomposition (by income source) of average Net Replacement Rates in the short and long term, by Unemployment Benefits entitlement status.

The role of Social Assistance and the extent to which public support is targeted at the bottom of the distribution is made explicit by looking at the average Compensation Rate by household income quintile group for those entitled to unemployment benefits in the short term (Figure 2). The most striking pattern is observed in the UK: due to Social Assistance, and the decreasing effect of the contributory Unemployment Benefit the Compensation Rate shows a decreasing pattern from a 57 per cent for the new unemployed from the first quintile group to 14 per cent for those at the top of the income distribution. It is also clear that the cushioning role played by Family Benefits (mainly the means-tested Child Tax Credit and the Working Tax Credit). On the one hand, from the second quintile on, increases in these benefits contribute to a higher Compensation Rate (and in particular the presence of someone still working in the household may trigger entitlement to Working Tax Credit). On the other hand, at the very bottom of the distribution, households where the only earner becomes unemployed lose their entitlement to the Working Tax Credit contributing to a lower Compensation Rate.

In the other countries, the average Compensation Rate decreases with income quintile but to a lesser extent than in the UK. Social Assistance emerges as a component of public support for those at the bottom of the income distribution in Belgium, Estonia and, above all, the Netherlands. Moreover, the role of income tax paid on unemployment benefits in reducing the overall Compensation Rate is not negligible in the Netherlands and in Belgium, Estonia and Spain for those at the top of the income distribution.

Figure 2: Decomposition (by income sources) of average Compensation Rates
for those entitled to Unemployment Benefits by household income quintile groups

The extent to which tax-benefit instruments allow the new unemployed to avoid falling below a given level of income depends on the generosity of the system, entitlement to receive unemployment benefits, the income position of the new unemployed before becoming unemployed and their household circumstances.

As shown in Table 3, the share of those at risk of poverty before unemployment ranges from around 2-4 per cent in the Netherlands, the UK, and in Belgium to much higher levels in Spain, Italy and Estonia (around 9-12 per cent). Among the new unemployed entitled to unemployment benefits, in the UK 44 per cent are at risk of falling below the poverty threshold on becoming unemployed. The percentages for the other countries are 30 per cent in Italy, 27 per cent in Estonia, 18 per cent in the Netherlands, 17 per cent in Spain and 11 per cent in Belgium.

As expected, the situation is worse in the long term when benefits are exhausted. Less than half of the new unemployed are protected from poverty, with larger shares of people at risk of poverty than in the short term in all countries (except the UK). However, it is when looking at the sole earners that the dramatic share of those inadequately protected by the welfare system becomes clear: in Estonia only 4 per cent of the new unemployed receive enough public support to stay above the poverty threshold, and around 12-14 per cent in Belgium, Spain and Italy. In the Netherlands and the UK, the Social Assistance schemes allow up to 21 per cent and 26 per cent, respectively, of the new unemployed to stay above the poverty threshold.

However, the share of the new unemployed not protected by the welfare system, when unemployment benefits are exhausted, supports the view that social protection for working age individuals has become less adequate and social redistribution less pro-poor. Social Assistance schemes do not stop those losing their job from descending into poverty.
The evidence presented here suggests that the current crisis will put minimum income schemes in several EU countries to a severe test. To meet the challenge, social safety nets must become stronger and tighter.

Such evidence raises the issue whether the tax-benefit system should ensure a minimum level of living standards for all individuals potentially at risk of unemployment or alternatively should ensure a higher stabilization of income for those more attached to the labour market with a longer contributory history and permanent employment contracts. Even without analysing any macroeconomic effect of the Great Recession, these results indicate the extent to which unemployment benefits and public transfers in general stabilise household income and thus highlight the role they can play in boosting demand and consumption. Unemployment benefits can act as efficient social shock absorbers and play a counter-cyclical role. The same applies to minimum income schemes, so long as extending their coverage and/or improving adequacy are part of the policy agenda.

Note: This summary was drafted by Francesco Figari. The full paper (including data) can be read at: https://www.iser.essex.ac.uk/publications/working-papers/euromod/em3-12

From issue no. 159, October 2012, pp.7-10.

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