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Employment Insurance in Canada: Does the current framework cause regional disincentives to remain active in the Labour Market?

By: Malinda Peck April 9,2012 _____________________________________________________________________________________ Introduction Much of the existing research on Employment Insurance (EI) discusses how reemployment incentives can become distorted through the presence of Moral Hazard. In economics literature, Moral Hazard is defined as a change in behavior, sometimes to the detriment of another, after a transaction such as insurance has taken place. More specifically to the EI market, Green and Riddell define it as a greater likelihood that recipients of EI will become or remain unemployed for longer durations. (Green, Riddell, 1993) The complexity of the Canadian EI system raises a very interesting question about whether observed differences in an agents behavior towards reemployment can be attributed to their geographical location. The reason for a potential asymmetry in behavior is that EI is far more accessible to those who live in regions with a higher unemployment rate. To put this in perspective, the C.D. Howe Institute reports that, based on 2008 employment records, 57.3% of job losers in Ottawa qualified for the benefits, compared to 93.5% in Restigouche/Albert, a rural region in New Brunswick. (Busby,Gray, 2011) Proving that there is a higher probability of Moral Hazard in high unemployment regions will be the main focus of this paper. My argument will proceed as follows: I will first give a brief overview of the EI system in Canada in order to provide the reader with a general idea about the framework that exists. Because there are many different characteristics between high and low unemployment regions, the main assumptions that are used will be carefully outlined. This paper will then discuss two theoretical concepts presented by earlier literature, which are important to our understanding of why different households may react Student ID:084501150

differently to the benefits. This will set up the discussion on how the existing benefit eligibility requirements may distort incentives. Although much of my analysis will focus on the presence of moral hazard through increased unemployment durations, I will also compare expenditures between the highest and lowest unemployment regions in order to show that there is a lack of precautionary savings in the former. Brief Overview of Employment Insurance in Canada The Employment Insurance program in Canada is designed in a way that allows for asymmetric distribution of the funds. According to the Service Canada website, the program is funded through employer and employee premiums which are paid on insurable earnings. The system is designed so that the government can diversify away some risk across regions. (Green, Riddell, 193) As mentioned in the introduction, regions with higher rates of unemployment are given more generous benefits, and its recipients are also usually approved for longer durations. According to the Government of Canada website, regions with the highest unemployment rates are predominately rural. Provisions which are referred to as Variable Entrance Requirements stipulate unemployed individuals who are living in a low unemployment region (which is classified as under 6%), are to have worked at least 700 hours in the preceding 52 weeks to qualify. On the other hand, individuals living in high unemployment regions (13% or greater) require only 420 hours in the same period to qualify. (Busby,Gray,2001) It is not difficult to see that a laid-off individual in a low unemployment region will have greater difficulty qualifying for the benefits. Canada is split into 58 different regions based on unemployment rates. As of March 2012, the regions in Canada with the highest unemployment rates were Yukon, The Northwest Territories, Nunavut and Northern Manitoba with rates at 25% or more. According to the same source, areas with the lowest unemployment rates include Regina, Halifax, Calgary and Edmonton, with rates under 6%.

(For a list of the different EI regions in Canada with their associated unemployment rates, see Appendix). It is important to note that Yukon, the Northwest Territories and Nunavut are not split up further into different unemployment regions. Therefore, their regions include cities such as Yellowknife and Whitehorse. However, these cities have population sizes around 20,000 according to their official websites. In contrast, the population size of Vancouver is 578,041, 1,365,200 for Calgary and 297,043 for Halifax. Because of the contrast in sizes, I do not consider Yellowknife and Whitehorse as urban cities in this analysis. Furthermore, because the definition of rural varies, for the purposes of this paper, I will reserve the definition for regions with low population densities that are not located near urban cities. Assumptions Before proceeding, it is important to outline the assumptions used in this paper since there are some very notable differences between the regions that could influence re-employment patterns. One very obvious difference is the number of employment opportunities in rural and urban areas. There will generally be a greater abundance of jobs in urban city centres due solely to the fact that the population sizes are much larger. However, I assume that greater competition for these jobs through a larger pool of qualified candidates, as well as greater accessibility through a more efficient transit system nullifies any relative advantage that this may present for an urban city dweller. Another difference worth noting is that individuals living in rural areas are more likely to own their house rather than rent, which is more common in urban areas. According to the 2006 census conducted by Statistics Canada, about 85.1% of residents in rural regions owned their house, compared to 64.5% in urban areas. However, in this paper I will not make a distinction between home owners and renters for two main reasons. The first is because whether or not a house acts as an asset depends on where an individual is in their mortgage cycle. In fact, a household is more likely to be constrained if

there are current mortgage payments to be met. (Chetty, 2008) If we compare homeowners with current payments and those with a paid off mortgage, the analysis becomes more complex, because it also becomes a question of demographics since there is a greater possibility that an individual with a paid off mortgage is older and possibly retired. If this is the case, they will have a greatly reduced income stream and are therefore not necessarily wealthier. Because it becomes difficult to distinguish the groups, I assume that these two effects cancel each other out. Furthermore, I believe it is more meaningful to focus on liquid assets because it is unlikely that owning a house will negatively change job search behavior. A house is not generally observed as a liquid asset that can be used to smooth consumption in an unemployed state, except under very extreme circumstances. Interaction of the Liquidity Effect and Moral Hazard Effect It is important to understand which underlying factors, if any, are more likely to influence job search behaviour and why some Economists theorize that different households will react differently to EI. One factor that is mentioned in literature pertaining to EI is pre-existing wealth. The reason why this is interesting in the context of this analysis is because we know that rural regions such as the Yukon and Northwest Territories are generally more constrained than their urban counterparts. Chetty decomposes the effect of an increase in the EI benefit level on search intensity into two distinct channels: The Liquidity Effect and the Moral Hazard Effect, arguing that when an individuals consumption cannot be smoothed between the two states, increasing the benefit level is more likely to distort behaviour. (Chetty, 2008) He uses the following equation to illustrate how an increase in the benefit level (bt) lowers the search intensity (st) through two distinct channels.

The first expression on the right hand side is the liquidity effect, and represents an agents cash on hand. This effect shows the marginal change in search intensity caused by an increase in the benefit level, using the logic that an increase in EI can be thought of as an increase in cash on hand. This allows the individual to enjoy a higher level of consumption while unemployed, and the pressure to find a new job is reduced. (Chetty, 2008) The second expression represents Moral Hazard, and shows the marginal change in search intensity with respect to a change in the net wage. In this model, net wage is defined as wages less taxes and benefits. In other words, as the benefit level increases, the net wage decreases, which lowers the incentive to re-enter the job market, assuming that an individual places a positive value on leisure. Using panel data on income and labour participation between the years 1985-2000, Chetty uses a hazard model to show the probability of remaining unemployed after t weeks. The observations are divided into 4 different quartiles based on net wealth. What he finds is that higher EI benefits lead to significantly lower job finding rates among the lowest quartile. However, this effect virtually disappeared when he observed the third and fourth quartiles (which are the higher earning observations). Chetty interprets this as EI inducing very little moral hazard among unconstrained households, with the opposite being the case for constrained households. (Chetty,2008) Hazard Rates and Job Match Quality When discussing EI, Economists often refer to a hazard rate which is defined as the unemployment exit rate. (Chetty, 2008) Some Economists such as Centeno focus their analysis on the effects of EI on post unemployment tenure and wages. (Centeno, 2002) One argument that has been made is that extended EI benefits allows workers to search for employment longer, resulting in a better job match that may increase post unemployment wages and tenure. (Centeno, 2002) Although this may lead to a tempting argument that longer unemployment durations do not necessarily lead to Moral

Hazard, we must keep in mind how Moral Hazard is defined in this analysis. In the introduction, I have defined it as the likelihood that recipients are more likely to become or remain unemployed for longer durations. The crucial point here is not how an individual is spending his time while unemployed, but rather that a distortion exists because the opportunity cost of the time spent unemployed has been lowered, and the individuals reservation wage has been increased. For example, in the absence of generous benefits, an unemployed individual may accept a low wage job that is not a perfect match to his skill set. Assuming that the job search ends here is an unrealistic oversimplification, since nothing is preventing the individual from resuming his search for a more suitable job after accepting the low paying one. Whether or not more generous benefits is subsidizing leisure or an extended job search, the fact still remains that the individual remains unemployed for a longer duration than would be the case in the absence of these benefits. In his analysis, Centeno finds that increases in EI benefits are associated with lower hazard rates. Tying this back to our analysis, although there were no hazard rate data readily available for the regions we are examining, the theory would predict that hazard rates would be lower in the Yukon, Northwest Territories and Nunavut compared to Halifax, Edmonton and Calgary due to the more generous benefits in the former. Chetty found that among households in the lowest quartile of the wealth distribution, a 10% increase in EI benefits decreases the hazard rate by 7.2%. By contrast, the relationship between EI benefits and hazard rates gets weaker as we compare households that are less constrained. Again, since we know that the regions we are considering are generally more constrained, this further supports the theory that the hazard rates will be lower in these regions. Skewed Variable Entrance Requirements and Observed Moral Hazard behavior As mentioned earlier in the paper, the minimum entry requirements (also known as Variable Entrance Requirements) are far more stringent in regions with lower unemployment rates. In their

paper, Christofides and McKenna study the relationship between employee behavior and these requirements. However, an important assumption must be made. In their analysis, the authors theorize that once the minimum requirements have been satisfied, employees who exhibit moral hazard will quit their jobs in order to receive the insurance. (Christofides, McKenna, 1996) Due to reforms to the Canadian system, candidates need to have been relieved from their positions through no fault of their own to qualify for EI. Even with this restriction in place, the analysis by Christofides and McKenna is still useful because we assume that individuals who wish to be let go from their current positions can greatly affect this probability through their actions. Employers may also be reluctant to terminate employment through more hostile means (such as by means of firing) since this becomes a matter that can become disputed and may result in a lawsuit or intervention from the Labour Board. Using data from the years 1986-1987, which consisted of 89,947 job records, the authors find a very clear correlation between employment termination and the achievement of the minimum work hours to qualify for the insurance. In their analysis, they compared Newfoundland and Ontario. At the time, Newfoundland had an entrance requirement of ten weeks, while Ontario had a minimum entrance requirement of fourteen weeks. The findings were very consistent with their original hypothesis, with employment termination spiking after ten weeks of employment in Newfoundland, and fourteen weeks in Ontario. (Christofides,McKenna,1996) It is very easy to see how this information can be transferred to the analysis in this paper. As mentioned in the Overview, the EI benefits are not only more generous in areas affected by high unemployment, but the Variable Entrance Requirements are also greatly skewed in their favor. Using the three observed regions, Yukon, Nunavut and the Northwest Territories, the number of insured hours to qualify for benefits is only 420. When we compare this to our low unemployment regions, Halifax, Calgary or Edmonton, the minimum hours required is 700. Based on the findings of Christofides and McKenna, it can be deduced that the more favorable Variable Entrance Requirements in high unemployment regions will be more likely to encourage Moral Hazard behaviour.

Consumption patterns and lack of precautionary savings Another effect to consider is how saving and consumption patterns differ between regions with high versus low unemployment. Holding all else constant and assuming risk aversion, an individual who faces more uncertain employment prospects should, theoretically, hold a greater proportion of their income as precautionary savings. However, this is not the type of behavior that is observed. Akyeampong finds that precautionary savings for future security (in the form of pensions, unemployment insurance and RRSPs) tended to be higher in urban areas. (Akyeampong, 1990) I use the 2009 Statistics Canada Spending Report to show how spending patterns differ across the regions in question. The same consumption basket was used for all the regions, which included items such as food, shelter, gifts, clothing and recreation. Assuming a Keynesian Consumption Function: c= + (y-t), we = ).

can also get an idea of savings patterns between the different regions, where in this model,

Comparing the results from the spending report to our observed areas with the lowest unemployment rates, the region with the highest average spending per household was Calgary with an average expenditure of $95,187. Edmonton was the second highest with average expenditure of $80,527. Regina and Halifax had the lowest average expenditure at $67,961 and $69,550 respectively. An important finding was that the areas we look at with the highest unemployment rates, Nunavut, Northwest Territories and Yukon also showed higher levels of average expenditure at $84,439, $82,966 and $69,856 respectively. Since we know that these areas have lower income, and assuming = ),

this means Since we assume that all disposable income is either consumed or saved, this is consistent with the earlier findings of Akyeampong. Conclusion Based on the evidence above, it becomes apparent that Moral Hazard is more likely to be observed in regions with predominantly higher unemployment rates. Studies indicate that urban city

residents are on average wealthier than their rural counterparts. This observation allows us to apply the moral hazard and liquidity constraint theory presented by Chetty since the evidence allows us to compare two regions that are relevant to the analysis; one that is constrained and one that is unconstrained. Using hazard rates can also give us a clearer idea as to how behaviours change among constrained and unconstrained households. Variations in the entry requirements also allow us to observe how generous benefits often lead to an incentive to become unemployed. Because we see variations in the required hours among urban and rural households, we can determine by the findings of Christofides and McKenna that minimum requirements skewed in favor of individuals in high unemployment regions acts as a disincentive to remain employed. The consumption behavior also gives us a good idea about an individuals attitude towards future unemployment and their relative dependence on EI, where areas with the highest unemployment rates exhibited the lowest level of precautionary savings.


Akyeampong, Ernest,1990. Consumer Spending in urban and rural Canada, Perspectives on Labor and Income,2 Busby, Colin & David Gray, 2011. Mending Canadas Employment Insurance Quilt: The Case for Restoring Equity, C.D. Howe Institute, No. 144 Centeno, Mario, 2004. The Match Quality Gains from Unemployment Insurance, The Journal of Human Resources, Vol.39 No.3, 839-863 Chetty, Raj, 2008. Moral Hazard vs. Liquidity and Optimal Unemployment Insurance, NBER Working Paper No. 13967 Christofides, L.N. & C.J. McKenna, 1996. Unemployment Insurance and Job Duration in Canada, Journal of Labor Economics, Vol.14 No.2, 286-312 Green, David A. & Craig W. Riddell, 1993. The Economic Effects of Unemployment Insurance in Canada: An Empirical Analysis of UI Disentitlement, Journal of Labor Economics, Vol.11 No.1, S96-S147 Statistics Canada; Changing Patterns in Canadian Homeownership and Shelter Costs, 2006 Census 2006, Catalogue No. 97-554-X Statistics Canada; Rural and Small Town Canada Analysis Bulleting, March 2002, Vol.3 No.7, Catalogue No. 21-006-XIE Statistics Canada; Spending Patterns in Canada, 2009, Catalogue No. 62-202-X


Province / Territory

Economic Region Code

Economic Region Name

Number of Insured Hours Unemployment Required to Rate Qualify for Regular Benefits 7.4 17.5 11.5 13.3 10 5.8 7.2 11.3 15.7 630 420 490 420 560 700 630 490 420 420 700 630 700 665 630 560 560 560

Minimum Number of Weeks Payable for Regular Benefits 17 37 28 31 25 14 17 28 35 31 14 22 14 15 17 20 25 25

Maximum Number of Weeks Payable for Regular Benefits 40 45 45 45 45 36 40 45 45 45 36 45 36 38 40 44 45 45

Newfoundland 01 and Labrador Newfoundland 02 and Labrador Prince Edward 03 Island Nova Scotia Nova Scotia Nova Scotia 04 05 06

St. John's (map) Newfoundland / Labrador (map) Prince Edward Island (map) Eastern Nova Scotia (map) Western Nova Scotia (map) Halifax (map) FrederictonMoncton-Saint John (map) MadawaskaCharlotte (map) RestigoucheAlbert (map)

New Brunswick 07 New Brunswick 08 New Brunswick 09 Quebec Quebec Quebec Quebec Quebec Quebec Quebec Quebec Quebec 10 11 12 13 14 15 16 17 18

Gaspsie-les-dela-Madeleine 13.3 (map) Quebec (map) Trois-Rivires (map) South Central Quebec (map) Sherbrooke (map) Montrgie (map) Montreal (map) Central Quebec (map) North Western Quebec (map) Lower Saint Lawrence and North Shore (map) Hull (map) ChicoutimiJonquire (map) 5.3 7.4 4.9 6.5 7.9 9.4 9.3 9.4

Quebec Quebec Quebec

19 20 21

9.7 5.4 6.1

560 700 665

25 14 15

45 36 38

Ontario Ontario Ontario Ontario Ontario Ontario Ontario Ontario Ontario Ontario Ontario Ontario Ontario Ontario Ontario Ontario Ontario Manitoba Manitoba Manitoba Saskatchewan Saskatchewan Saskatchewan

22 23 24 25 26 27 28 29 30 31 32 33 34 35 36 37 38 39 40 41 42 43 44

Ottawa (map) Eastern Ontario (map) Kingston (map) Central Ontario (map) Oshawa (map) Toronto (map) Hamilton (map) St. Catharines (map) London (map) Niagara (map) Windsor (map) Kitchener (map) Huron (map) South Central Ontario (map) Sudbury (map) Thunder Bay (map)

6.3 8.3 7.2 7.2 7.9 8.6 6 7.6 8.6 10 10.9 6.7 9.7 5.2 7.2 5.2

665 595 630 630 630 595 700 630 595 560 525 665 560 700 630 700 525 700 700 420 700 700 665

15 18 17 17 17 18 14 17 18 20 21 15 20 14 22 14 26 14 14 37 14 14 15

38 42 40 40 40 42 36 40 42 44 45 38 44 36 45 36 45 36 36 45 36 36 38

Northern Ontario 11 (map) Winnipeg (map) Southern Manitoba (map) Northern Manitoba (map) Regina (map) Southern Saskatchewan (map) Northern Saskatchewan (map) Calgary (map) 5.8 5.7 28.8 4

Saskatoon (map) 5.8 6.4

Saskatchewan Alberta Alberta Alberta Alberta British Columbia British

45 46 47 48 49 50 51

18.1 5

420 700 700 595 700 595 525

37 14 14 18 14 18 21

45 36 36 42 36 42 45

Edmonton (map) 6 Northern Alberta 8.7 (map) Southern Alberta 5.8 (map) Southern Interior British Columbia 8.8 (map) Abbotsford (map) 10.8

Columbia British Columbia British Columbia British Columbia British Columbia Yukon Northwest Territories Nunavut 52 53 54 55 56 57 58 Vancouver (map) 6.7 Victoria (map) 6 665 700 595 490 420 420 420 15 14 18 28 37 37 37 38 36 42 45 45 45 45

Southern Coastal British Columbia 8.1 (map) Northern British Columbia (map) Yukon (map) 11.6 25

Northwest 25 Territories (map) Nunavut (map) 25