Institute of Policy Studies of Sri Lanka Sri Lanka: State of the Economy 2007 Empowerment of the Poor

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12. Unemployment Insurance

12.1 Introduction Sri Lankas severance pay system, based on the Termination of Employment of Workmen Act of 1971, has long being criticized for its indistinctness, cost and lack of uniformity. Although reforms introduced in 2003 (and later amended in 2005) were aimed at improving uniformity of severance pay levels, the costs remained high and terminating workers still require the approval of the Commissioner of Labour. Studies for other countries show that high firing costs reduce employment generation in the formal sector, push workers into the informal sector and reduce the efficient allocation of workers across the economy. Literature for Sri Lanka has also argued that the present severance pay system is at least partly responsible for the high share of informal sector employment in the country estimated at anything between 40-60 per cent of total employment and the low levels of job creation and job mobility. Reforming the present severance pay system requires the introduction of an alternative system to protect workers against the income variability associated with job-loss. One such alternative suggested is the introduction of an unemployment insurance (UI) scheme. At present, according to International Labour Organization (ILO) statistics, just over 50 countries have UI schemes with most being developed countries. Many of these countries have adopted a combination of active and passive policies to provide compensation to the unemployed and to help them get re-employed. The usual active labour market policies include job search assistance, training prorgammes and specific employment programmes targeting the unemployed. The passive labour market policies include UI schemes and early retirement plans. Introducing an unemployment insurance scheme in a developing country setting is complicated for several reasons. Most UI schemes are designed for countries with a large share of their workers in the formal sector. As UI schemes can create adverse employment effects, many countries closely monitor the behaviour of UI beneficiaries. Such sophisticated UI schemes can be costly to administer and finance. Nevertheless, several policy documents in the recent past have recommended the introduction of a UI scheme in Sri Lanka. The coverage, terms and conditions of eligibility and benefits, financing mechanisms and administration of a UI scheme needs to be designed giving due considerations to the specific labour market conditions of a country. This policy brief

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attempts to shed light on some issues concerning the introduction of an unemployment insurance scheme in Sri Lanka and provides recommendations on addressing these issues. 12.2 What is Unemployment Insurance? Unemployment insurance is a type of social insurance. It aims to protect workers from income loss associated with unemployment. Such schemes allow governments to smooth consumption through provision of income protection to workers. Although private insurance schemes can also serve the same purpose, they may not be as effective given that a higher proportion of workers who are more likely to lose jobs for various reasons may enrol in these programmes (i.e., adverse selection). Rigid dismissal rules and high levels of severance pay compensation given to workers during dismissals can also in a sense, protect workers from income loss. But these types of regulations protect income through protecting jobs and may be less efficient as they are shown to restrict job mobility, impede industrial restructuring, and reduce investments. Despite these positive aspects, UI schemes can adversely affect labour markets by distorting individual and firm level decision making. The literature has pointed to several ways in which UI can lead to problems of moral hazard. First, workers who receive unemployment benefits may wait longer to re-enter the labour market, and they may not exert as much effort in looking for a new job. As a result, unemployment levels may increase, which in turn will reduce economic growth on one hand, and increase demand for social benefits on the other. Second, workers may also have higher reservation wages as a result of UI benefits, and may increase demand for wages. In fact, cross-country studies for OECD economies indicate that the rise in unemployment in Europe from the 1960s to mid 1990s is partly due to changes in labour market institutions, such as UI schemes. Given such problems associated with implementing UI schemes and the high cost of providing UI benefits, the main challenge for many countries has been to design UI schemes that balance the objectives of worker welfare and economic growth. In an attempt to improve job search during unemployment benefit periods, some countries have introduced measures to monitor job search behaviour and penalize individuals usually by reducing payment amounts or stopping payments -- who do not satisfy job search standards. In other instances, some countries pay higher unemployment benefits at the start of the unemployment spell, or provide bonuses for individuals who find employment sooner. Although these types of incentives and punitive measures have improved job
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search efforts during unemployment spells, they can be costly to administer and requires sophisticated administrative capacity. In addition to the general problems discussed above, there are specific problems relating to implementing UI schemes in developing countries. First, UI schemes are designed keeping formal sector workers in mind. Usually, only workers who have a prior employment history and those who have become unemployed due to involuntary reasons qualify to receive unemployment benefits. Workers are usually given a percentage of the wages they were receiving prior to unemployment. Unlike for formal sector workers, establishing employment behaviour and amounts of wages received will be difficult for informal sector workers. For this reason, most UI schemes only cover formal sector workers. In developing countries where a majority of workers are in the informal sector, UI schemes covering formal sector workers will be less effective in smoothing consumption. Second, as discussed earlier, due to sub-optimal behaviour of individuals subjected to UI schemes, effective implementation of UI schemes require close monitoring of individual behaviour and reliable information on employment and earning history of individuals. The management capacity of developing countries may not be equipped to handle such demanding administrative functions. Further, having high administrative costs could reduce the amount of benefits available for distribution to the unemployed. 12.3 Why an Unemployment Insurance Scheme would be Useful for Sri Lanka The main argument for introducing an unemployment insurance scheme in Sri Lanka is the high costs and time consuming procedures associated with firing workers. The World Banks 2007 report on Doing Business groups Sri Lanka in the ten countries with the highest cost of firing workers. Literature for Sri Lanka as well as other countries shows that rigid labour markets reduce investments and impede growth. One proposition put forward to improve flexibility of the labour market and reduce delays of business restructuring is the introduction of an unemployment insurance scheme. This could reduce job protection which distorts the allocation of workers and reduces the size of the formal labour market while insuring workers against income loss associated with job loss. However, as highlighted earlier, the nature of the labour market and the complexities and costs associated with administering, makes the introduction of a UI scheme a challenging exercise for countries such as Sri Lanka.
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12.3.1 Issues Concerning the Introduction of an Unemployment Insurance Scheme in Sri Lanka The key issues related to the introduction of an unemployment insurance scheme in Sri Lanka concern financing, benefits, administration, and coverage. The EU countries spend the most amount of funds on unemployment programmes. On average, around 1 per cent and 2 per cent of GDP is spent by EU countries on active and passive labour market policies, respectively. An important consideration in the design of an unemployment insurance scheme is the means of financing the scheme. Key concerns here are whether it should be financed from workers pay, employers payroll taxes, or general taxes. Most unemployment assistance programmes for other countries are financed through contributions from employees and employers. Even among developed countries, very few cover the entire cost of unemployment assistance programmes through public funding two exceptions to this rule are Australia and New Zealand. In some countries, the cost of administering the programme is covered by the government, while in others the government provides temporary assistance or makes deficit payments. Unemployment insurance extends usually to workers who have lost formal jobs. Further, the literature suggests that it is the more privileged and the non-poor who are able to secure jobs in the formal sector. According to the 2006 4th Quarter Labour Force Survey conducted by the Department of Census and Statistics (DCS), 61 per cent of workers in the Sri Lankan labour market are in the informal sector. Given this, it is not welfare improving to fund an unemployment insurance scheme in Sri Lanka using public funds. Any proposed UI scheme should be entirely funded through a contributory system. The level and duration of the unemployment benefits has also to be determined. The literature highlights the need to choose the level and duration of unemployment benefits with care, as long duration payments and high levels of benefits can dissuade beneficiaries from re-employment. The challenge is to reach a compromise between providing an adequate level of benefits to allow beneficiaries to maintain their lifestyles, but to keep the levels of benefits sufficiently low, so that they have an incentive to find alternative employment quickly. Usually, unemployment benefits are a percentage of the average earnings during a specified period. These rarely exceed 75 per cent of earnings. Some countries vary the amount of benefit given over time, to induce individuals to seek employment faster. Others impose waiting periods before the receipt of unemployment
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benefits to reduce unnecessary movements into unemployment and to reduce the administrative burdens of handling large numbers of small benefit amounts. The payment periods are less than 26 weeks for most countries. The means by which an unemployment insurance scheme is to be administered in Sri Lanka also requires some attention. Administering an unemployment insurance scheme involves collecting UI contributions, checking the eligibility criteria for potential beneficiaries, and making payments. The amount of administrative effort needed for an unemployment insurance scheme depends on the complexity of the scheme. For most countries, the levels of contributions are a simple percentage of the earnings of the employee, or the pay roll of the employer. As such, these are easy to administer. However, some countries such as the United Kingdom have different contribution levels for different types of employees. This will require more administrative effort as the UI scheme administrator will need to collect information to establish the type of worker. To qualify for unemployment insurance, most countries require that workers are capable and willing to work, and that they register with an employment office. These conditions are relatively easy to establish. However, in addition to these basic requirements, some countries also require that beneficiaries show that they are actively looking for work. Some countries combine unemployment benefit schemes with retraining programmes to facilitate re-employment. Still other countries have complex benefit systems, which provide incentives for workers to find alternative jobs quickly. Incorporating these sophisticated conditions could be administratively more difficult, as this requires tracing beneficiaries over the duration of their unemployment period. Further, when a higher share of the UI contributions are spent on administering the scheme, less is available for the beneficiaries. Given this, for countries such as Sri Lanka, where monitoring job search behaviour and labour market activity would be relatively costly, the different functions of the UI scheme should be kept simple. Some simple means of calculating and delivering benefits suggested include the following:1 (i) (ii) the elimination of personalized monitoring of job-search behaviour and the labour market status, which, in turn, enables making direct deposits of benefits to the savings account of the unemployed, as well as

Vodopivec, M. (2003), Introducing Unemployment Benefits to Sri Lanka, The World Bank, HDNSP.

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the simplification of benefit payments by using existing institutions and simple benefit payment rules.

Who should be covered by the UI scheme is another key issue. In most countries, eligibility for unemployment insurance requires that an individual has made a specific number of contributions towards the UI scheme or has been in employment covered by the UI scheme for a specific period. Usually, only workers who have become unemployed involuntarily are eligible for benefits. These requirements imply the need for prior employment under formal employment contracts. As such, mainly workers in the formal sector are covered by the scheme. According to DCS Labour Force Survey data, close to 90 per cent of the unemployed in Sri Lanka are first time job seekers. As unemployment schemes are intended for those who have lost jobs due to economic fluctuations, these types of workers will not benefit from UI schemes. However, they may misunderstand the objectives of the unemployment insurance scheme, and may demand benefits. This could lead to social and political unrest in the country. Thus, significant attention will need to be paid to introducing an unemployment insurance scheme to raise public awareness, to avoid such misunderstandings. 12.4 Conclusions Many research studies in the past several years have highlighted the need to relax regulation on retrenching workers in Sri Lanka. The present legislation in Sri Lanka protects workers against income variability through employment protection. International evidence shows that high levels of employment protection limits economic growth by reducing job creation and job mobility. One solution to this problem is the introduction of an unemployment insurance scheme which can protect workers from income loss, while allowing job mobility. However, UI schemes can be costly and difficult to administer and usually only covers workers in the formal sector. They can also have adverse employment effects such as increasing the period of unemployment and increasing the demand for a higher wage. An unemployment insurance scheme for Sri Lanka needs be take into consideration these issues in its design. This policy brief argues that given only formal sector workers who are mostly non-poor will primarily benefit from an unemployment insurance scheme for Sri Lanka, it should be financed through a contributory scheme by the workers and the employers. Further, the policy

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brief argues that the unemployment payments should be kept simple in order to keep the costs of administering the UI scheme low.

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