Why should the government provide income protection in a recession?

Unemployment insurance payments would be insufficient to offset the large income losses due to coronavirus and the ensuing recession. Governments are stepping in to provide much-needed income support to households that face significant declines in their monthly income.

The significant decrease in productive activity as a result of the pandemic and the lockdown means that the UK economy is likely to record negative economic growth in 2020. Such recessions are often characterised by high unemployment, as companies and business owners lay off workers to reduce their operating costs and ensure the longevity of their businesses.

Although Covid-19 is first a health crisis, it could become an economic disaster for households that do not have a reserve of savings to see them through months in which they lose income. In this situation, the government is ideally placed to provide income protection beyond what would normally be available in unemployment insurance payments such as Universal Credit.

What does evidence from economic research tell us?

Gross Domestic Product (GDP) measures the value of all goods and services produced within an economy in a specific year. For that reason, GDP is also considered a measure of productive activity and economic growth.
GDP can also be measured as the sum of total demand for finished goods and services in an economy, called aggregate demand. Aggregate demand is calculated as the sum of spending undertaken by households, businesses and the government.
The Covid-19 recession is a negative shock to aggregate demand: businesses close or have less business, thereby reducing their profits. This may cause business owners to lay off employees, which means household incomes are reduced. These households then have less income to spend on output from businesses that are still operating, which will reduce profits further and could, in turn, motivate businesses to retrench yet more employees.
The government can implement policies, called demand-side policies, which can increase aggregate demand to affect output, employment and inflation. Income protection policies constitute an expansionary fiscal policy aimed at supporting household incomes and increasing spending in the economy.
During the 2008/09 global financial crisis, the German government introduced ‘Kurzarbeitergeld’ or ‘short-work money’, which is an income protection policy where laid-off workers received 60% of their pre-crisis pay from the Federal Labour Office, the agency responsible for issuing unemployment benefits. The scheme was hailed as one of the reasons why Germany’s economy recovered rapidly following that crisis.
Realising that unemployment insurance payments would be insufficient to offset the large losses in household incomes, governments are stepping in to provide much-needed income support to households that face significant declines in their monthly income.

How reliable is the evidence?

The concepts and mechanisms underpinning aggregate demand has been researched and studied since the Great Depression of the 1930s, and now form the basis of many textbooks on introductory economics. Since then, governments have routinely used fiscal expansion policies to support economic activity and employment during recessions.

Many advanced economies provide unemployment insurance to support livelihoods while the unemployed search for another job. To avoid abuse of the system, these people are required to register with an employment service and prove they are actively searching for work.

There is evidence, however, which suggests that unemployment benefits could (negatively) change the behaviour of those people that receive the payment (Bailey, 1978). Receiving an income during a spell of unemployment could change the wages that a person would be willing to accept, and thus extend the duration of unemployment and represent a greater burden to the government (Card and Levine, 2000). Research has now suggested an ‘optimal’ payment structure that would ensure people continue to search actively for work while receiving unemployment benefits (Chetty, 2008).

Unfortunately, the procedures associated with unemployment insurance schemes can prove cumbersome in the face of an economic crisis with a rapid onset, such as the coronavirus. In the United States, many state unemployment departments were overwhelmed by the sudden exponential increase in unemployment insurance claims, and the crashing of various state department websites was well documented in the news (Bell and Blanchflower, 2020).

For this reason, governments have resorted to innovative income protection measures to prevent a sudden and rapid increase in unemployment. These measures include schemes that ensure that businesses retain their staff and employees receive a portion of their pre-crisis income. The benefit of these schemes is that they do not alter the incentive structures of those affected: furloughed workers do not alter their search patterns as they remain on their company payroll, while businesses benefit from keeping staff with specialist skills and company-specific experience.

Related question: How does the government's furlough scheme work?

What can research tell us about the impact of income protection policies?

In the UK, the government anticipated the labour market would be especially hard hit by the crisis and announced a series of reforms intended to protect households against income losses resulting from Covid-19-related business closures. The Coronavirus Job Retention Scheme (CJRS) and the Self-Employment Income Support Scheme (SEISS) were introduced to limit the negative impact on household income and unemployment, and the Chancellor has since then announced that the scheme will be extended until the end of October. The Office for Budgetary Responsibility (OBR) estimates that will bring the total cost of the scheme to £63 billion to July.

The CJRS in its current form ensures that furloughed employees across the UK continue to receive 80% of their current monthly income up to a limit of £2,500. The scheme will continue in its current form until the end of July, after which changes to the scheme will allow more flexibility starting in August 2020. Two key amendments to the scheme is that employees who move to part-time work will have part of their salary covered by the CJRS and employers will have to bear a part of the cost currently covered by the government. Recent statistics published by HM Treasury suggest that the CJRS has protected 7.5 million workers to date.

Consistent with the Treasury statistics, the Office for National Statistics (ONS) Business Impact of COVID-19 survey (BICS) conducted between 6 and 19 April found that businesses that were still trading had furloughed 26% of their staff. With an estimated 22 million private sector employees in the UK, the ONS survey suggests that around six million employees are currently furloughed.

In their most recent quarterly forecast, the National Institute of Economic and Social Research (NIESR) indicated that the unemployment rate could increase temporarily to 10% of the workforce in the second half of the year. Some early research suggests that in the absence of these schemes, employees would have lost 53% of their net family income if they lost their job, and an estimated 9.5 million employees would have lost more than 60% of their family income had they been made redundant. Thanks to the CJRS, households are now only likely to lose 13% of their net family income and only 300,000 employees would lose more than 60% of their family income should they lose their jobs (IFS, 2020).

What further evidence is needed?

Given that these fiscal expansion policies ratchet up government debt, it is useful to determine the actual impact that it has on unemployment, household income and economic activity. Further research could also indicate how the government could most effectively fund the debt incurred during the pandemic.

Additional research will also need to identify any gaps in the income protection policies that will allow governments to target the families and households that are most vulnerable. As lockdown measures are eased in the coming months, there will also need to be significant research conducted to establish how to adapt the current measures and introduce further strategies to support businesses and households returning to work in a low demand environment.

Some initial policy suggestions (Dube, 2020) include job sharing to preserve existing jobs, providing compensation for employees facing reduced hours, and extending existing unemployment insurance schemes to provide relief to families and businesses.

The Resolution Foundation has stressed that forthcoming amendments to the CJRS must be flexible to varying timetables for change, as well as account for different impacts across the economy. The recommendation is for a scheme that allows for full hourly flexibility commencing in June, with health enforcement measures ramped up as employees return to work.

Where can I find out more?

Why we're seeing mass layoffs in the US but not the UK: Vox compares how well-timed government policies can affect labour markets.

Getting the UK back to work: Researchers at the IFS discuss the difficult trade-offs the government face in deciding when and how to ease lockdown restrictions.

Macroeconomics of the flu: Beatrice Weder di Mauro suggests how policy-makers could respond to a Covid-19 induced recession.

Chancellor extends furlough scheme until October: HM Treasury outlines plans to extend the furlough scheme with greater flexibility to get employees back to work and boost the economy.

Filling the holes in family and business budgets: unemployment benefits and work sharing in the time pandemics: Arindrajit Dube discusses alternative policies that could reduce unemployment and buoy economic activity in the US.

Getting Britain working (safely) again: Torsten Bell, Laura Gardiner and Daniel Tomlinson set out possible changes to the CJRS that will allow enough flexibility and support during the interim phase of the lockdown.