Earnings limits are common in disability insurance programs but may hurt beneficiaries: insights from reform in Hungary

The share of working-age adults receiving long-term disability insurance (DI) benefits has increased rapidly over the last few decades across many countries. The trend in disability rolls raises concerns about the fiscal sustainability of DI programs and has prompted policy makers to examine program designs that encourage potential beneficiaries to remain employed and those already receiving benefits to return to work. Policies that can keep individuals employed for a longer time are especially important as societies age and governments would like to encourage older workers and workers in less good health to remain active in the labor market.   

One way that policy makers try to limit DI take-up and incentivize work is setting earnings limits: if a beneficiary earns above a certain level, she loses part or all of her benefits. Earnings limits are meant to ensure that only workers who are unable to earn above a certain level will apply for benefits, while potential applicants with higher working capacity will find it more advantageous to forego benefits and remain employed instead. Benefit designs based on a cash-cliff, where workers lose all their benefits if they earn above a threshold, essentially assume that if an applicant can earn more than the threshold amount in the labor market, they do not need to receive any DI benefits. Policy makers and researchers have recognized that cash-cliff style earnings limits create strong work disincentives and have potentially negative welfare impacts.  Alternative policy approaches adopted in other countries avoid a notch in the benefit schedule by introducing a gradual phaseout of benefits above an earnings threshold. But even under these policy designs, the implicit tax rate may still inefficiently distort labor supply.

Our recent study provides evidence on the impact of decreasing the earnings limit for moderately disabled individuals in Hungary, who selects to participate in the DI program and how much they work once they start receiving benefits. In 2008, the earning limit in Hungary's Regular Social Assistance (RSA) program for moderately disabled individuals was reduced from 80 percent of the individual's last wage before entering disability, to 80 percent of the monthly minimum wage for new entrants, while it remained the same for beneficiaries who were already approved. We study this policy change to understand how selection into the program and labor supply once in the program changed. We compare the evolution of various measures of labor supply relative to the start of benefit receipt among beneficiaries who enter before and after the reform.

Reducing the earnings limit only moderately changed who took up disability insurance

We find that the decrease in the earnings limit had a small impact on selection into the program. First, we do not find evidence of decreased program entry rates. Second, we show that individuals who entered the program after the reform had only slightly worse pre-entry labor market outcomes than beneficiaries who entered earlier. New entrants were 3 percentage points less likely to work and earned 8 percent less on average, conditional on working, pre-entry than existing entrants (Figure 1). Existing and new entrants were similar on a variety of other dimensions, such as age, occupation, geographical location, and sick leave use prior to entering disability. Examining benefit persistence, we find no evidence that new entrants were more likely to exit the program than existing entrants.

Figure 1: Evolution of Hours Worked Before and After Taking Up Benefits Among Old and New Entrants

Lowered earnings limit led to significantly lower labor supply among benefit recipients

At the same time, we find that individuals who entered the program after the earnings limit was reduced had meaningfully lower labor supply post-entry. New entrants were as likely to be employed as existing entrants, but conditional on being employed, they worked less. On average, new entrants worked 7 percent fewer hours (Figure 1) and had 18 percent lower earnings, conditional on working, after taking up benefits. 

This result is driven by beneficiaries with higher pre-disability earnings, who were most affected by the change in the earnings limit. Figure 2 displays heterogeneity by reform exposure, comparing beneficiaries for whom the decrease in the earnings limit was likely binding and those for whom it was likely not binding, because their earnings were too low to be affected by the new limit. The first panel shows earnings relative to the minimum wage for beneficiaries who earned below the minimum wage three years before taking up RSA benefits. Among this lower-earning group we find that the small pre-entry earnings gap of 6percent between existing and new entrants persists post-entry at about 9 percent. The second panel shows the same comparison for beneficiaries who earned above the minimum wage three years before taking up RSA benefits. For this group, there is a sharp increase in the earnings gap between existing and new entrants from 4 percent pre-entry to 21 percent after taking up benefits. This suggests that workers with higher earnings potential reduce their labor supply in order to remain eligible for the disability benefit.

Figure 2: Evolution of Earnings Before and After Taking Up Benefits Among Old and New Entrants by Pre-Disability Earnings Level

Governments may need to carefully evaluate the unintended consequences of earnings limits in disability insurance programs

Overall, our results suggest that decreasing the earnings limit only led to a moderate change in who takes up benefits.  The moderate selection effects are consistent with a world where the earnings limit and the benefit level were already sufficiently low to deter most potential entrants who were well-positioned to find higher-paying jobs in the labor market. At the same time, the reform substantially distorted the labor supply of program participants. These empirical findings suggest that the overall impact of the reform on efficiency and welfare was negative. The reform failed to yield sizable cost savings from benefit expenditures for the government, but left moderately disabled individuals with lower earnings, resulting in lower tax revenues in turn. At the given benefit level, a higher earnings limit would therefore be optimal. More broadly, this suggests that governments need to account for the potential negative effects of earnings limits and also consider other tools for improving the efficiency of DI programs.