Social security and employment

The social security system provides a safety net during illness, disability and unemployment and its purpose is to ensure reasonable income in all situations and to narrow income differences and differences in wellbeing. However, generous social security benefits weaken incentives to work and the social security contributions collected from employers affect the demand for labour.

Providing social security in a welfare state is challenging: the safety net must be comprehensive, while at the same time, it must be ensured that it does not unreasonably discourage people from seeking employment. Improvements in the social security system should be guided by research on how the benefits and the contributions collected to finance them impact the behaviour of employees and employers and, consequently, employment. For this reason, since its establishment, VATT has carried out extensive research on social security and its effects on income distribution and employment. Some of our studies on the employment impacts of social security are listed below.

Level of unemployment benefits

Numerous changes have been made to the level of earnings-related unemployment benefits over the years. Studies show that generous unemployment benefits prolong unemployment spells, make recipients less likely to accept part-time work, and lower earnings in the two years following the beginning of the unemployment spell.¹^,² Under the activation model, in effect in 2018 and 2019, the unemployment benefit were reduced for a fixed period if the unemployed person did not work or participate in active labour market programmes during a review period. Even though the activation model made unemployed people more active, its direct employment impacts could not be reliably separated from business cycle effects.³ In a study now under way, we are assessing the impacts of paying unemployment recipients higher benefits for periods when they are participating in labour market training.

The purpose of the adjusted unemployment benefits is to encourage unemployed jobseekers to accept part-time or short stints of work when more permanent full-time jobs are not available. The earnings disregard introduced in 2014 has made such partial employment financially even more attractive. Microsimulations show that the adjusted unemployment benefit combined with earnings disregard make work during unemployment an economically attractive option to most household types.⁴ In fact, working during unemployment benefit receipt has become more common throughout the 2010s. Supporting partial employment is beneficial because it increases the chances of finding full-time work at a later stage.⁵

Duration of unemployment benefits

The length of the entitlement period of earnings-related unemployment benefits has been reduced in recent years. Studies show that the potential duration of unemployment benefits has a significant impact on the behaviour of the unemployed. This is partially reflected by the fact that a small number of unemployed jobseekers wait until the end of their entitlement period.⁶ However, this group does not have any major impact on public finances or the average duration of unemployment spells. What is much more important is that unemployed jobseekers react to the potential duration of unemployment benefits well before their benefits expire. Being entitled to unemployment benefits for longer periods also means longer unemployment spells but longer job search periods lead to better job matches.⁷ This latter observation suggests that many jobseekers use longer benefit entitlement periods to search for jobs matching their skills. Finding a better job partially compensates for the costs of spending a longer time as a jobseeker.

Unemployment tunnel

The oldest unemployed jobseekers are entitled to extended unemployment benefits after their regular benefit period. Long-term unemployed born before 1950 were eligible for unemployment pension at the age of 60, and those born after that can continue on extended unemployment benefits until they retire on old-age pension. The combination of regular and extended benefits, which provide earnings-related unemployment benefits up until retirement, is called the unemployment tunnel scheme. In the 1990s, one became eligible for this scheme at the age of 53. Over the years, the minimum age has been raised several times and the scheme will be gradually phased out so that those born in 1965 and after are no longer eligible for the extended benefits.

Studies show that the unemployment tunnel has significantly reduced employment among the oldest age groups. The risk of unemployment increases significantly as employees reach the minimum required age because those eligible for the unemployment tunnel tend to be laid off first.⁸ Few of these individuals return to employment and a large proportion of the unemployed eligible for the scheme are just waiting to reach the retirement age.⁹ It is estimated that raising the minimum required age from 55 to 57 has increased the length of working careers in the private sector, on average, by seven months.¹⁰ According to the most recent study, the unemployment tunnel scheme has increased unemployment especially in occupational groups performing work tasks that are more easily replaced with computers and robots.¹¹

Basic income experiment

The focus in unemployment benefits research has been on recipients of earnings-related benefits whose chances of finding work are significantly better than of those relying on basic unemployment allowance and labour market subsidy. There is a significantly higher number of long-term unemployed among recipients of flat-rate unemployment benefits provided by the Social Insurance Institution of Finland (Kela). They are also more likely to receive means-tested income transfers, which make accepting employment much less attractive to them. Means-tested income transfers also involve a great deal of bureaucracy. An internationally ambitious experiment was carried out in Finland 2017 and 2018 to find out whether basic income could provide a workable alternative to the existing system. VATT was actively involved in the planning and implementation of the project.

In the experiment, the unemployment benefits paid by Kela were replaced with a monthly basic income of EUR 560. The experiment was carried out by randomly selecting 2,000 unemployed jobseekers as basic income recipients for a two-year period. The basic income was provided as a tax-free and gratuitous benefit, which significantly increased incentives to work. At the same time, the recipients were not obliged to seek work or make use of the activation measures. The findings suggest that the experiment only had modest employment impacts. However, the simultaneous introduction of the activation model makes it difficult to interpret the results.¹² Basic income recipients continued to make extensive use of unemployment benefits and used the services provided by the labour administration almost as before. The results of the experiment suggest that better employment incentives, gratuitous nature of the benefit and dismantling of bureaucracy do not significantly boost employment among recipients of Kela-provided unemployment benefits.

Large employers

Finland’s social security system is to a large extent financed with employers’ contributions. Determining and allocating these contributions impact the demand for labour in companies. By paying contributions, the largest companies also pay for some of the costs arising from their own actions. For example, large employers pay a part of the costs arising from the unemployment pensions or extended unemployment benefits of their former employees. In other words, funding for the unemployment tunnel scheme partially comes from the companies making active use of the scheme. This arrangement has to some extent discouraged companies from using the scheme when laying off employees.¹³

A similar mechanism is also used in the financing of disability pensions. Until 2005, large employers had to pay a proportion of the future costs of disability pensions as a lump sum in the year when their employees were granted this type of pension. The prospect of this payment liability reduced the number of sickness benefit periods and the number of sickness benefit recipients retiring on a disability pension. In other words, it encouraged employers to invest in wellbeing at work and measures helping to maintain work capacity.¹⁴

With the introduction of the International Financial Reporting Standards, the co-insurance model for disability pensions was replaced with the experience-rating model in 2006. There are no longer any one-off payment liabilities in the current model as the employers pay experience-rated contributions (or payroll taxes) for all their current employees. The contribution rate is determined on the basis of the disability pensions granted to the firm’s employees in preceding years. Even though the principle is the same as in the co-insurance model, the contributions in the experience-rating model are determined in a more complex way. There is no indication that the experience-rating model has had any major impacts on the number of new sickness or disability benefits although the existence of moderate effects cannot be ruled out.¹⁵

Entrepreneurs

Entrepreneurs have some control over the size of their pension insurance contributions. By opting for lower contributions, an entrepreneur will have to settle for a smaller pension and for less generous social security in case of illness or disability. According to a recent study, entrepreneurs opt for lower pension contributions and less generous social security when provided the opportunity to do so. In newly established companies, the money saved in this manner is invested in growth, whereas in older companies it is used to strengthen the balance sheet.¹⁶

The owners of unlisted companies have an incentive to arrange the salary and dividends that they receive from the company so that the combined total of taxes and social security contributions can be minimised. Such income shifting between salary and dividend income is a key tax planning instrument for entrepreneurs who can pay themselves a salary and receive dividends from their company. Tax planning makes it more difficult for the government to tax entrepreneurs and impact their productive activities. In the case of unlisted companies, tax planning is a concrete problem because a study has shown that it accounts for more than two thirds of the behavioural impacts of income taxation.¹⁷