Why younger Australians need a stronger welfare safety net

If the Coalition is serious about growth, it should lift unemployment benefits for the young and reduce middle-class welfare.

What would you say if I said that instead of cutting youth unemployment benefits, we should increase them?

What would you say if I said that unemployment benefits should rise for the young, but be reduced for older people?

That might seem strange, or at least inequitable, but it might also be economically rational. A recent paper by economists Claudio Michelacci and Hernan Ruffo argues that US economic welfare would rise if unemployment insurance was increased for young workers and decreased for old.

Their argument centres on the fact that wages, wealth and spending tend to differ over the course of a person’s life. Our needs and resources increase as we approach middle-age, get married, have children and reach the pinnacle of our careers. Then, as we head towards retirement, our spending moderates and eventually declines.

The authors observe that workers’ incentive to find a job also varies over the course of their life. We know that is true since labour force participation differs considerably across age groups; in most countries participation is lowest among the youngest and oldest cohorts.

These differences mean that unemployment benefits may provide different incentives or disincentives for different age groups. It begs the question: what is the optimal structure for unemployment benefits?

Their research tackles this question by measuring the welfare gains of marginally increasing unemployment benefits for different age groups. Higher unemployment benefits increase the income of the recipient and raises their spending.

In classical economics we assume that higher income and spending increases the welfare of the recipient. It is assumed that people receive a diminishing marginal utility from consumption, which basically means they take less enjoyment from each additional dollar spent.

Utilising data from the Panel Study of Income Dynamics, the Current Population Survey and the Survey of Income and Program Participation, the authors find that in the US the welfare gains from unemployment benefits are unambiguously larger for younger workers compared with older workers.

The rationale is that younger workers have a limited ability to smooth their consumption between periods of employment and unemployment. As a worker gains more experience, and saves and invests, they are better able to navigate periods of unemployment.

That can be seen in the following graph, which compares spending patterns for employed and unemployed people. The values diverge significantly when people are younger but gradually converge as people enter middle-age.

A secondary consideration for any welfare program is whether it provides a significant disincentive to find work. To be clear, any program that increases your non-work income will create a disincentive by reducing the return on finding a new job. But often that disincentive is minor and more than offset by the welfare generated by the benefits received.

According to the authors, the moral hazard created by providing a safety net for young people is very low. Furthermore, the research finds that the duration of unemployment for older workers is highly affected by benefits. This suggests that the moral hazard problem -- the disincentive to find employment -- is actually higher among older than younger workers.

That’s perhaps a surprising find for some Australian readers. We’ve been conditioned to believe that unemployed young people are deadbeats who prefer to rely on the government rather than finding a job. This research is obviously US-based, but there is no good reason to believe that Australian youngsters are fundamentally different to their American brethren.

So what does the optimal welfare system look like? Well, it’s fair to say that American ‘baby boomers’ are unlikely to approve.

The research suggests that unemployment benefits should replace around 80 per cent of wages for workers in their mid-20s (from 50 per cent currently) and 60 per cent for workers in the 30s. Workers in the 40s and 50s obtain almost no benefits.

In practice, such a policy would be met with widespread anger across the electorate, particularly in a country such as the US where the median voter is quite old and younger voters turn out in poor numbers.

But the research does provide some insight into recent developments in Australia. Assuming that Australians have similar life-cycle properties as Americans -- a reasonable assumption by my estimates -- the Coalition’s welfare reforms are damaging to the Australian economy.

Since the May budget I have argued that the cuts to welfare for younger Australians would weigh on economic growth because (a) the marginal propensity to consume among young Australians is very high; and (b) there are few jobs for this group to find.

This research is consistent with those views and suggests that if the Coalition was serious about growth it would instead have provided a stronger safety net for younger Australians. Less harm would have been done to the economy by cutting middle-class welfare.