Considering a “Federalized” Unemployment Insurance Scheme for Europe

Leila Davis and Harry Konstantinidis

Leila Davis is an assistant professor of economics at Middlebury College. Harry Konstantinidis is an assistant professor of economics at the University of Massachusetts-Boston. Their paper “A Proposal for a Federalized Unemployment Insurance Mechanism for Europe,” with Yorghos Tripodis, is available here.

The length and depth of the ongoing Eurozone crisis highlights design failures in the monetary union’s architecture, and points to the need for concrete analyses of institutions and policies that can contribute to a more stable EMU architecture. In fact, discussions aiming to resolve the Greek crisis within the euro cannot be limited to the current debt crisis, but must also explore policies at the Eurozone level that may mitigate weaknesses inherent in EMU structure.

One direction for reform emphasizes fiscal transfers across Eurozone countries, which have received growing attention in both academic and policy circles over recent months. In fact, during the summer of 2015, the IMF explicitly recommended direct fiscal transfers to the Greek budget to help quell the Greek debt crisis. The logic for fiscal transfers in a monetary union is well known: because countries in monetary unions have neither independent monetary authority nor exchange rate control, they have limited policy options with which to respond to domestic shocks. In the EMU context, the Stability and Growth Pact also limits the use of fiscal policy during downturns.

In a recent working paper (coauthored with Yorghos Tripodis) we examine a “federalized” EMU-wide unemployment insurance (UI) system, whereby basic unemployment benefits are provided at the Eurozone—rather than the domestic—level, is one policy scheme that may contribute to a more stable EMU-level architecture. Such a scheme is in the spirit of the U.S. system, in which federally funded unemployment insurance reduces pressure on individual states’ budgets following asymmetric shocks. UI, which supports both household incomes and aggregate demand during downturns, is a key component of fiscal crisis management.

Furthermore, because UI is an automatic response to downturns, it also constitutes an otherwise largely un-relievable portion of a country’s fiscal spending. UI spending in the five EMU countries most directly impacted by the Eurozone crisis—Greece, Italy, Ireland, Portugal and Spain—increased between 2008 and 2012. In Ireland, for example, UI spending as a share of total government expenditures increased 90%, from 2.9% to 5.4% of total spending. Simultaneously, total Irish government spending contracted 5.6%.

The basic objective of an EMU-wide UI scheme would be to guarantee short-term unemployment assistance at the EMU level: the EMU-wide fund would cover a certain amount of each member state’s unemployment benefits, while each country would then be able to top off additional benefits. Three sets of issues arise: fiscal feasibility, institutional design, and political feasibility. With respect to fiscal feasibility we consider whether a particular institutional design is consistent with a positive stock in the proposed EMU-level UI fund, throughout the business cycle and without requiring funding taxes high enough to generate adverse employment effects. Contributions to the fund would be determined on the basis of a payroll tax paid on each country’s taxable wage base—in line with most existing UI contribution schemes—and benefit pay-outs would reflect a constant percentage of each country’s minimum wage to the short-term unemployed (or an imputed minimum wage, for countries without official minimum wages). This institutional design has an important advantage of linking each country’s contributions and benefit pay-outs to the size of its own wage base. Benefit levels can, accordingly, be high enough to support incomes and aggregate demand in higher-income countries, without providing benefits that exceed any country’s minimum wage. Variations on this institutional design can also be considered. Of particular interest is “automatic triggers” providing for extended-duration benefits, and therefore providing additional household income and aggregate demand support, in case of a particularly severe crisis.

Calculations based on aggregate data for all years of the EMU, including projections through 2020, indicate that an EMU-wide UI system is fiscally feasible in the Eurozone context. The payroll tax necessary to finance the scheme does not exceed 1.5%, which is less than or equal to existing payroll taxes in most EMU countries. Importantly, despite the depth and duration of the post-2008 Eurozone crisis, the size of the fund remains positive. In fact, with a 1.5% payroll tax and benefit levels covering 45% replacement of the country-specific minimum wage, the fund would accumulate a significant surplus over time and, accordingly, also be sufficiently large to provide extended benefits in deep recessions on the basis of the automatic triggers mentioned above.

Perhaps the greatest obstacle to the implementation of any policy increasing integration across EMU countries relates to political feasibility, and while the question of political feasibility is multi-dimensional and complicated, at least two relevant consequences of a “federalized” UI system can be isolated. First, an EMU-wide UI system is expected to stabilize output in EMU countries currently in a downturn. Given the extent of intra-European trade, policies supporting demand in one part of the EMU should support trade and, thus, aggregate demand in other parts of Europe. Second, sustained distributional consequences across Eurozone countries are limited, with each country’s net contributor or benefactor status strongly reflecting its underlying growth rate. Of course, this feature is a consequence of the institutional design: linking both contributions and benefits to each country’s wage base, and also to each country’s business cycle reduces the likelihood of long-term transfers across EMU countries.

EMU-level UI is not, of course, a panacea to either the ongoing Eurozone crisis or to structural problems aggravating the crisis. Unemployment insurance constitutes, in fact, a relatively small portion of government expenditure. Thus, while our calculations suggest that “federalizing” UI can help stabilize output for EMU countries currently in recession, the independent effect of UI on output is likely to be limited. However, such a scheme is one concrete and fiscally feasible proposal that can contribute to a larger set of institutional reforms. Furthermore, UI highlights the role of fiscal transfers extended via automatic stabilizer as a useful approach to addressing (asymmetric) crises across Eurozone countries. Because the expansionary effect of fiscal policy is stronger in recessions—when there is considerable “slack” in the economy—than during expansions, fiscal transfers via automatic stabilizers orient EMU-wide spending to countries in which fiscal spending will currently have the strongest effect.

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