The share of working-age adults receiving long-term disability insurance (DI) benefits has increased rapidly over the last few decades and DI programs currently account for over 10% of social spending in OECD countries. This development has led to a search for effective policies that help reduce the public cost of disability insurance.
One way that policy makers try to limit the take-up of DI benefits and incentivize work is setting earnings limits: Once beneficiaries earn above a certain level, they lose their benefits. The rationale behind earnings limits is the presence of asymmetric information: As the government cannot observe applicants’ true health status or work capacity, it must rely on a screening mechanism. The screening mechanism is supposed to ensure that only workers who are unable to earn above a certain level will apply for benefits, while potential applicants with higher working capacity will find it advantageous to forego benefits and remain employed instead.
While a tight earnings limit might thus be a suitable screening device that keeps entry into the program low, it may also create strong work disincentives for benefit recipients. This may especially be the case in labor markets with high earning risks where the benefit provides a stable source of income for recipients. When setting the earnings limit, policy makers thus face a tradeoff between the selection (or screening) effect of the earnings limit and the labor supply effect.
Selection and labor supply effects
In a recent IZA Discussion Paper, Judit Krekó, Daniel Prinz and Andrea Weber first formalize this idea in a theoretical framework that explains what happens if the government decreases the earnings limit in the DI program. In this case, the set of workers who apply for benefits shrinks as only less-productive workers will prefer benefit receipt and limited work.
At the same time, another effect is at play: Conditional on receiving benefits, a lower earnings limit means that beneficiaries will set their labor supply lower in order to remain eligible for benefits. The authors call these two effects of changing the earnings limit the selection and labor supply effects. At the optimal earnings limit, the selection effect and labor supply effects of moving the earnings limit will balance each other out for the marginal entrant. For policy design it is thus important to estimate these effects empirically.
Reform in Hungary
In the second part of the paper, the authors study a reform that reduced the earnings limit form 80% of the pre-disability wage to 80% of the minimum wage in Hungary’s Regular Social Assistance (RSA) program for the moderately disabled. Importantly, the reform only applied to new entrants taking up benefits as of January 1st 2008, while it remained the same for beneficiaries who were already approved.
The paper exploits this policy change to understand how selection into the program and labor supply once in the program changed. To this end, the study compares the evolution of various measures of labor supply relative to the start of benefit receipt among beneficiaries who enter before (“old entrants”) and after (“new entrants”) the reform date.
The empirical analysis results in three main findings. First, the authors find that the decrease in the earnings limit only had a small impact on selection into the program. There is no evidence of decreased program entry rates. But consistent with the screening mechanism, individuals who entered the program after the reform had worse pre-entry labor market outcomes than beneficiaries who entered earlier.
Second, though exit from DI benefits is not common even among the moderately disabled beneficiaries, a further margin that could have been potentially affected by the earnings limit is the probability of staying on the program. There is no evidence that new entrants were more likely to exit the program than old entrants.
Third, it is found that individuals who entered the program after the earnings limit was reduced had meaningfully lower labor supply post-entry. While new entrants were as likely to be employed as old entrants, they worked less conditional on being employed. This labor supply response is driven by beneficiaries with higher pre-disability earnings, who were most affected by the change in the earnings limit.
Forth, to examine the impact of the lowered earnings limit on beneficiary health, the authors consider mortality, an imperfect measure of health. Their results suggest no change in mortality which means that the primary effect of the reduction of the earnings limit on beneficiaries was through reduced work.
Overall, the results suggest that decreasing the earnings limit only led to a moderate improvement in screening efficiency. This evidence is consistent with a scenario where the earnings limit and benefit level before the reform were already sufficiently low to deter potential entrants who are well-positioned to find higher-paying jobs in the labor market.
At the same time, the reform substantially distorted the labor supply of program participants. Viewed through the lens of the model, the empirical findings suggest that the overall impact of the reform on efficiency and welfare was negative. The authors conclude that the reform failed to yield sizable cost savings from benefit expenditures for the government, but left moderately disabled individuals with lower earnings, resulting in lower tax revenues in turn. At the given benefit level, a higher earnings limit would therefore be optimal.