Friday, February 20, 2009

How Employer-Based Health Care Makes the Recession Worse

It is by now reasonably well known that American subsidization for home ownership has contributed to our current economic woes. The combination of the home mortgage interest deduction, low interest rates, banking deregulation, and the bubble that ensued, all in turn allowed lenders to externalize foreclosure risks, until the bubble burst. And this leaves us with bad options: People who are underwater and either walk away or go into foreclosure further exacerbate bank losses and real estate devaluation, while people who stay in their underwater homes lack the mobility that might enable them to find work elsewhere. (For a fuller version of the case against home ownership---and more---see Neil's posts here, here, here, and here.)

Here I want to note how another familiar American institution---employer-based health insurance---impedes economic recovery. A small number of public and private employers have experimented with unpaid furloughs and reducing hours in response to hard times (smaller budgets for public sector employers; reduced demand for goods and services of private firms). Yet on the whole, cuts have meant layoffs, rather than reductions in hours worked. And as a growing number of experts have begun to realize (and was explained to me by my colleague Bob Hockett) that's unfortunate.

Consider a schematic example. Suppose that a sporting goods store employs a sales staff of 10 people, each working 40 hours per week, for 400 worker-hours. And let's assume that all sales staff earn the same hourly wage. Now let's suppose that reduced demand means that in order to maintain a measure of profitability, the store needs to reduce its staff to 320 worker-hours. It could lay off 2 workers but it might alternatively reduce all workers to 32 hours per week, with corresponding pay cuts. The latter approach would share the pain more equitably and at the macro level would have less of a negative cascading impact on the economy as a whole. By contrast, under the layoff approach, the two completely laid-off workers require unemployment insurance compensation and may default on home loans or other debts. Meanwhile, the remaining 8 workers start tightening their belts and saving as much of their paychecks as possible, thus reducing demand for goods and services and exacerbating the recessionary spiral. When the pain is spread among all 10 workers, a higher percentage of the total wages paid will end up back in the economy because, with less disposable income (due to the reduced hours), the 10 workers can save less than could 8 workers at higher incomes. And that is to say nothing of the adverse psychological consequences that go with outright unemployment.

To be sure, not all tasks performed by all workers are interchangeable in the way that the foregoing illustration assumes. For instance, demand for ski equipment might drop by a larger margin than demand for guns and ammo, and so, assuming specialized knowledge, it would make sense to simply lay off one of two ski equipment salespeople rather than to cut both of their hours and reassign some of their hours to gun sales. But these sorts of issues aside, there could be circumstances in which an employer would be at least indifferent as between some layoffs and some hours reductions, or might even favor the hours reduction as a way to recoup investments in human capital should the business climate eventually improve.

Nonetheless, our system (if it can be called anything so rational as a system) of employer-based health care distorts employers' incentives by lowering the marginal cost of additional hours for existing workers relative to the cost for new workers. The employer who pays 10 workers for working 32 hours each plus health care benefits pays more than the employer who pays 8 workers for working 40 hours each plus health care benefits. The benefits are basically a fixed cost per worker, more or less independent of how many hours he or she works. For high-wage employees, Social Security contributions exacerbate the problem, because of the regressive nature of payroll taxes: neither employer nor employee makes payments on income over $106,800 (in 2009).

Even with the help in paying for COBRA that the stimulus plan provides, it's pretty obvious that our regime of employer-based health care will make life very difficult for laid-off workers and their families should they remain unemployed and develop serious health issues. But I'm suggesting that, on top of that, employer-based health care is going to make the downturn worse than it would be if we had either fully portable or single-payer universal health insurance. And that's not counting the health care costs that put American industry at a competitive disadvantage relative to firms in other countries even in good times.

Posted by Mike Dorf