When the Economy Slows, Spending on Incapacity Benefits, Health and Pensions Increases – and May Keep us Out of Recession

RES logoIn the last of our podcasts supporting the Royal Economic Society Conference 2008, Romesh Vaitilingam talks to Jacques Melitz about how increased spending on Social Security benefits may help to keep us out of recession.

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Increased public spending on incapacity benefits, health and pensions can all help the economy recover in a slowdown or recession. That is one of the findings of new research by Professors Julia Darby and Jacques Melitz presented at the Royal Economic Society’s 2008 annual conference.

In a slowdown some policies help the economy recover automatically. A recession increases the total amount spent on unemployment benefit (as more people are claiming it) and reduces the total tax take (as people’s tax bills drop). This helps to stimulate the economy without any active government intervention.

The report finds that these automatic stabilisers play an even greater role smoothing the business cycle than previously thought. This is because programmes such as incapacity benefit, pensions and health spending all act as such stabilisers as well.

In fact, active government intervention may even destabilise the economy if it doesn’t properly take account of these automatic effects.

These benefits are likely to help prevent recession as spending on each of them grows as a slowdown starts:

  • Pensions: workers tend to retire at an earlier age in recessions and at a later age in booms. So pension payments are higher in recessions and lower in expansions. This is partly because employers encourage older workers to retire in recessions, as they are relatively more expensive to employ.
  • Health spending: older workers are also likely to be those with bigger health problems. Those who retire earlier in recessions may have especially severe health problems. In addition, retired people have more time to devote to health care. So health spending may increase in a recession.
  • Incapacity benefits: in the UK (among other countries), workers who are laid off in a recession and who qualify for incapacity benefit may turn to it instead of unemployment benefit. These have increased substantially over the last 25 years: total spending on such benefits is about 30% more than that on unemployment benefit across all developed countries.

These automatic stabilisers play an important role in stabilising economies in the OECD. For every pound reduction in output in a recession, it is generally thought that close to 50p flows right back to the private economy automatically through a fall in tax revenues and a rise in government spending.

This report shows that the contribution of government taxes and spending to automatic stabilisation is even higher than is generally thought. Significant contributions are also made through cyclical movements in retirement benefits, public health spending and invalidity benefits.

The contributions from these other sources of social spending are more than twice as high as those coming from unemployment compensation alone. As a result, following a fall of one pound in output, private income only goes down by 40p at most rather than by 50p on average.

This means that we tend to exaggerate the role of active fiscal policy in stabilising developed economies. The government gets too much credit for the automatic forces at work.

Moreover, we know from past studies that fiscal policy can sometimes destabilise the economy. During booms, this policy can occasionally overheat the economy by generating deficits. Based on their results, the researchers argue that such destabilising behaviour is actually even greater than previously thought since the behaviour was strong enough to overcome forces that now seem more powerful.

The study also has implications for the European Union’s Stability and Growth Pact. If automatic stabilisation is greater than generally believed, then staying within the 3% deficit limit is more difficult than previously thought during recessions. This may explain some of the difficulties that countries like France, Germany, Italy and Portugal have encountered in their efforts to meet the deficit ceilings in the last eight or nine years.

Notes for editors: Labour Market Adjustment, Social Spending and the Automatic Stabilisers in the OECD by Julia Darby and Jacques Melitz was presented at the Royal Economic SocietyĆ¢’s annual conference at the University of Warwick, 17-19 March 2008.

Julia Darby is at the University of Strathclyde. Jacques Melitz is at Heriot-Watt University.

For further information: contact Julia Darby on 07971 681210 (email: julia.darby@strath.ac.uk); Jacques Melitz on 0131 451 3626 or by email (J.Melitz@hw.ac.uk); or Romesh Vaitilingam on 07768 661095 (email: romesh@compuserve.com)

Read more research papers by Jacques Melitz at EconPapers. Intute: Social Sciences features more Internet resources on the topic of economics.

3 Responses to “When the Economy Slows, Spending on Incapacity Benefits, Health and Pensions Increases – and May Keep us Out of Recession”

  1. Intute: Social Sciences Blog » Blog Archive » When the Economy Slows, Spending on Incapacity Benefits, Health and Pensions Increases - and May Keep us Out of Recession Says:

    […] out more about this piece of research on the Economics in Action blog. Read more research papers by Jacques Melitz at EconPapers. Intute: Social Sciences features […]

  2. Amelie Griffiths Says:

    Our home business was really affected by the Economic recession, we have to cut jobs just to cover up our losses. fortunately, we have already recovered. :

  3. Bianca la Grange Says:

    After reading this blog I realised that an economy of a country is very complex and that one wrong decision can result in the economy’s downfall. It was very interesting to see that these three factors can play such a great role in stabilising the economy and I totally agree. Therefore it is so important for the government to have the appropriate knowledge to know what actions should be taken to either prevent or stabilise a recession the correct way.

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