The issue of productivity growth in Canada has received considerable attention reflecting its marked slowdown since the early 1970s and concerns about its implications for Canadian competitiveness. To better understand productivity developments in Canada, it is useful to decompose total factor productivity (TFP) into investment-specific productivity change (ISP) and technologically neutral productivity change (TNP). The gap in manufacturing productivity growth between Canada and the United States originates mostly in the strong performance of specific industries, such as electrical products and commercial and industrial machinery.

Abstract

The issue of productivity growth in Canada has received considerable attention reflecting its marked slowdown since the early 1970s and concerns about its implications for Canadian competitiveness. To better understand productivity developments in Canada, it is useful to decompose total factor productivity (TFP) into investment-specific productivity change (ISP) and technologically neutral productivity change (TNP). The gap in manufacturing productivity growth between Canada and the United States originates mostly in the strong performance of specific industries, such as electrical products and commercial and industrial machinery.

III. Experience Rating of Employment Insurance Premiums1

1. The high rate of unemployment in Canada in the 1990s drew considerable attention to the role played by unemployment insurance in contributing to the level and persistence of unemployment. While much has been done to reform unemployment insurance in Canada, with a concomitant decline in structural unemployment, some significant disincentives remain. In particular, the Employment Insurance (EI) system relies on uniform contributions from employers which are not linked to the costs they may impose on the program. The result is cross subsidization of industries that are more prone to generating unemployment by those with more stable employment2. The introduction of experience rating (whereby EI premiums paid by firms are set on the basis of the use of the system by their employees) would improve economic efficiency and work to lowering unemployment and raising output. It would introduce a new element of complexity in the system, but developments in the United States suggest that any increase in the cost of administering the system would not be prohibitive. The current practice of experience-rating premiums in provincial workers’ compensation programs in Canada also would support this conclusion. Moreover, the financial condition of the EI system at present provides a unique opportunity to introduce experience rating without imposing additional costs on those firms that currently are being heavily subsidized, by simply basing prospective EI premium reductions on each firm’s use of the system.

A. Some Theoretical Aspects of Unemployment Insurance

2. By its very nature, an unemployment insurance system financed out of general government revenues or through a uniform payroll tax introduces distortions into the labor market, as it affects the allocation of resources across sectors and creates undesirable incentives for employers and employees. Nevertheless, it also provides a safety net which serves an important social welfare function. In designing an unemployment insurance scheme, a key criteria is to minimize the distortions that it creates, while maximizing its social welfare benefits. Under a system financed with a uniform tax on employers, labor costs rise proportionately across industries, resulting in a partial shift of the costs of laying off workers from those with less stable employment patterns to those with more stable ones.3 By bearing part of these costs, the stable employment sectors contract relative to the unstable sectors, distorting the efficient allocation of resources, and raising the average instability of the economy. In addition, this type of system creates adverse incentives for employees and employers. Unemployed workers may postpone the acceptance of a new job due to the low costs of remaining unemployed, while employers have no incentives to offer workers less employment volatility in return for lower wages since workers are guaranteed earnings stability. Moreover, it can lead to collusion on the part of employees and employers to maximize unemployment benefits paid to the employees.

3. In contrast, an unemployment insurance system based on experience rating tends to increase efficiency and welfare by internalizing the costs for firms with less stable employment patterns. Under experience rating, the costs of labor fluctuations are allocated efficiently because they are imputed to those who can effectively control the rate of layoffs or transfers of workers between firms: the system ties a firm’s premium structure to its layoff experience4. Two important implications are that such a system provides some insurance to the employer (by smoothing tax payments over time) as well as the employee (by smoothing the income stream), and it eliminates any direct link between the degree of experience rating in the tax structure and the income smoothing provided to the unemployed. Full experience rating ensures that the relative marginal cost of labor does not change across industries, so that unstable sectors would not expand at the expense of stable sectors. In addition, experience rating provides better incentives to employers for minimizing temporary layoffs so as to reduce taxes paid. In sum, the objectives of incorporating experience rating into an unemployment insurance scheme are to create an incentive for employers to stabilize employment and minimize temporary layoffs; to appropriately and fairly allocate the costs of unemployment insurance across firms and industries; and to encourage employers to participate in monitoring how the unemployment insurance program is administered.5

B. Experience Rating in the United States

4. The United States is the only country to finance its unemployment insurance system with a firm-based experience-rated payroll tax, and has done so since the inception of the system in the 1930s. The unemployment insurance system in the United States is governed by both federal and state laws6. The Federal Unemployment Tax Act (FUTA) requires that payroll taxes are experience rated, but places no restrictions on how states implement experience rating. As a result, a variety of different methods have been adopted. The most commonly used is the reserve-ratio method in which each employer has an account where tax payments are deposited and benefits are withdrawn. The reserve ratio is the ratio of reserves in the employer’s account to the average taxable payroll of the employer over the last three to five years. Therefore, a high (low) reserve ratio reflects a firm that has paid in significantly more (less) in taxes than it has withdrawn in benefits. Accordingly, the payroll tax rate that an employer pays is negatively related to its reserve ratio (Figure 1). For firms with reserve ratios along the sloped part of the tax schedule, an additional layoff means an increase in the payroll tax rate. Once the maximum tax rate is reached, any additional layoffs will not result in a higher tax rate.

Figure 1.
Figure 1.

Experience-Rated Payroll Tax Schedule

(Reserve-Ratio Method)

Citation: IMF Staff Country Reports 2000, 034; 10.5089/9781451806922.002.A003

1/ Tax rates across states vary considerably. Maximum tax rates in 1999 range from 5.4 to 10 percent, and minimum tax rates range from 0 to 2.8 percent.2/ Equals ratio of reserves in employer’s account to average taxable payroll over the last three to five years.

5. Experience rating in the United States tends to be partial, in that taxes contributed by employers do not completely reflect expected benefits to be received by employees. Partial experience rating does not completely eliminate adverse incentives for employers and employees, resulting in higher temporary layoffs. A pattern of long-term employment attachment between employers and employees—e.g., like in the construction industry—can benefit both parties if the employer repeatedly lays off employees on a temporary basis. Given these implicit incentives, partial experience rating results in employers using temporary layoffs to take advantage of this subsidy, particularly during periods of low demand. A number of empirical studies suggest that if the United States had full experience rating, 20 to 50 percent of temporary layoffs could be eliminated.

6. Partial experience rating in the United States also means that some level of cross-subsidization among firms and industries remains. Employers in the highly cyclical industries pay less in payroll taxes than the benefits paid to their workers. As a result, other industries are subsidizing these benefit payments. A number of studies have consistently found that the construction industry—highly prone to layoffs—receives a subsidy because it generates more in unemployment benefits than paid in taxes. Anderson and Meyer (1993) estimated that over the period 1980–91 the average annual net subsidy to the construction industry arising from partial experience rating amounted to about $1.2 billion, or 0.6 percent of the industry’s output.

7. Some countries have experimented with experience rating and abandoned it (Sweden in the late 1950s and early 1960s), others have incorporated limited features (the Netherlands), or are considering its implementation (recently, Poland).7 The absence of experience rating on a wider scale may reflect a tendency in many countries to blur the distinction between unemployment insurance and social assistance. In the United States the unemployment system is more focussed on insurance aspects, and a separate system of social assistance programs exists to provide income support.

C. Employment Insurance in Canada and the Potential Impact of Experience Rating

8. Currently, Canada’s EI system is administered at the federal level, and it is financed through a uniform payroll tax applied to employers and employees.8 The level of total benefits paid to employees differs across employers and industries, depending on how cyclical and seasonal employment patterns are across employers, and also depending on the performance of the industry.9 Regional disparities in benefit/premium ratios are particularly important in Canada, with the Atlantic provinces being the largest net beneficiaries (Table 1). This pattern reflects the economic structure of these provinces, where largely seasonal resource-based industries account for most of provincial economic activity and unemployment is high. Forestry, fishing and trapping, agriculture, and construction have been the main beneficiaries of the EI system. Moreover, the Canadian labor market, like that of the United States, is characterized by significant employment turnover, outflows from the labor force are particularly high compared to other advanced economies outside North America (Table 2). High labor market turnover, together with inefficiencies stemming from the current EI system, suggest that Canada would benefit considerably from introducing partial or full experience rating.

Table 1.

Canada: Employment Insurance Benefits/Premiums by Industry 1/

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Source: The Report of the Technical Committee on Business Taxation (1998).

Based on 1989-90 average.

In percent of labor costs.

Table 2.

Canada: Indicators of Employment Turnover 1/

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Source: OECD (1996).

Measured as monthly flows into and out of unemployment. Inflows refer to those unemployed for less than one month. The number of outflows is estimated as the difference between the average monthly level of inflows and the monthly average change in unemployment over one year.

Data before 1991 are not available due to changes in the definition introduced in the 1992 European Community Labor Force Survey.

9. Beausejour, Sheikh, and Williams (1998) note that the current system has induced substantial variation in benefits received by firms within the same industry, and has possibly affected the participation rate of certain age groups, as youth have received a large share of EI net benefits. They emphasized that the distribution of net benefits across industries has been highly skewed toward a minority of industries, with those representing only roughly 40 percent of employment having received net benefits. Other studies have noted that the uniform unemployment insurance tax has resulted in significant subsidies between industries, and between provinces (Corak and Pyper, 1995). Vroman (1996) compared the level of interindustry subsides in Canada and the United States, and found that the pattern of subsidies was similar, but that the level of subsidies was 50 percent larger in Canada, mainly reflecting the presence of experience rating in the United States. Construction, followed by agriculture, forestry, and fisheries, were the main beneficiaries of the EI system. Services and transportation were the sectors most adversely affected by the system.

10. Beausejour, Sheikh, and Williams (1998) provide estimates of the allocative impact of a firm-based fully experience-rated EI system in Canada from a general equilibrium perspective. Based on a 95-sector model, which allows for firms to optimize employment decisions, introducing experience rating would reduce unemployment by about 2.2 percentage points—representing 45 percent of temporary unemployment and 23 percent of total employment—and would increase Canadian GDP by 2.2 percentage points.

11. Notwithstanding these benefits, the authors acknowledge that the analysis does not take into consideration the initial administrative complexities and costs of implementing such a system. Workers’ compensation programs in the provinces are experience rated. These programs are financed through employers’ contributions which vary across industries (and industry subsectors) in line with differences in the average accident experience. Individual rates are adjusted in relation to the amount by which an employer’s accident experience is above or below the average for its sector. This would suggest that the administrative complexities and costs of implementing experience rating in the EI system should not be insurmountably large.

12. In recent years, EI contribution rates have been declining, as EI receipts have exceeded payments by a sizable margin, and there is an expectation that rates will be reduced further over the next few years. The Report of the Technical Committee on Business Taxation (1998), along with other groups, has argued that Canada would have the opportunity to introduce some degree of experience rating without increasing the contribution rate of any single employer. Contribution rates for firms with stable employment patterns could be reduced by more than those with less stable patterns. Issues to be resolved include the measurement of experience, the number of rates, exemptions, and how employer contribution rates would vary with experience. The Committee acknowledged that the proposed system would increase administrative costs, but emphasized that these would be likely outweighed by the expected benefits of lower unemployment.

List of References

  • Anderson, P., and B. Meyers, 1993, “The Unemployment Insurance Payroll Tax and Interindustry and Interfirm Subsidies,” in Tax Policy and the Economy, James Poterba, ed., Vol. 7, pp. 111144.

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  • Beausejour, L, M. Sheikh, B. Williams, 1998, “Experience Rating Employment Contributions,” Canadian Public Policy, Vol. 24, No. 3, pp. 388393.

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  • Brechling, Frank and Louise Laurence, 1995, Permanent Job Loss and the U.S. System of Financing Unemployment Insurance, Kalamazoo, Michigan, W.E. Upjohn Institute for Employment Research.

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  • Corak, M. and W. Pyper, 1995, “Workers, Firms, and Unemployment Insurance,” Catalogue No. 73–505–XPE, Statistics Canada.

  • Levine, P., 1997, “Financing Benefit Payments,” in Unemployment Insurance in the United States: Analysis of Policy Issues, eds. C. O'Leary and S. Wandner, Kalamazoo, Michigan, W.E. Upjohn Institute for Employment Research.

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  • OECD, 1996, OECD Economies at Glance: Structural Indicators, Paris, OECD.

  • Report of the Technical Committee on Business Taxation, Submitted to the Honourable Paul Martin, Minister of Finance, December 1997.

  • Unemployment Insurance in the United States: Analysis of Policy Issues, 1997, eds. C. O'Leary and S. Wandner, Kalamazoo, Michigan, W.E. Upjohn Institute for Employment Research.

  • Vroman, Wayne, 1996, “An Analysis of Unemployment Insurance Experience Rating: Draft Report,” Urban Institute, unpublished paper, December.

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1

Prepared by Martin Cerisola and Paula De Masi.

2

The comprehensive reform of the system enacted in 1996 introduced some limited “experience” rating through an intensity rule which reduces benefits for workers who repeatedly use the system.

3

For a more comprehensive discussion, see Brechling and Laurence (1995).

4

The degree of experience rating could vary from zero (similar to a uniform payroll tax) to partial, to full (the tax rate is established according to employer’s risk class), or to complete (total payment by employer of its own employees claims). Partial experience rating arises when payroll taxes paid by the employer have a minimum and maximum rate, so that beyond a certain point, additional layoffs do not result in an increase in the employer’s payroll tax rate. Other factors that contribute to partial experience rating are when benefits are not charged to an employer’s account under certain conditions or in case of bankruptcy.

5

Contrary to the standard arguments made against experience rating, in terms of not inducing employers to change their layoff patterns and of unfairly penalizing volatile industries, Brechling and Laurence (1995) note that with market-determined prices and wages, it is unlikely that a single employer would be successful in avoiding the incidence of the tax by shifting its burden through higher prices or lower wages. They also note that evidence shows that employers do reduce the number of layoffs in response to a higher marginal tax costs of layoffs.

6

For a more detailed discussion, see Levine (1997) and Vroman (1996).

7

In the Netherlands, unemployment insurance premiums are differentiated at the sectoral rather than at the firm level. Although the behavior of individual firms is not affected, cross-subsidization between sectors is reduced. Experience rating is further limited because sectoral insurance schemes cover the first 26 weeks of unemployment, with the federal government providing extended benefits beyond this time period.

8

As of January 1, 2000, the premium rate for employees is $2.40 per $100 of insurable earnings up to the maximum of $39,000. The employers’ premium rate is 1.4 times the employee rate.

9

In addition, benefits are also provided for training and self-employment assistance, as well as for sickness, and maternity and parental leave.

Canada: Selected Issues
Author: International Monetary Fund