What is the best replacement rate?
Designers of benefit systems often feel they are on the horns of a dilemma. Paying higher benefits keeps beneficiaries (and their families) out of poverty. But higher benefits also cost more, and may reduce the gap between incomes out of work and incomes in work to such an extent that the incentive to work is undermined. Furthermore, taxes on earnings might reduce after-tax (‘net’) earnings even further.

Whether financial incentives to work influences whether people work or not is one of the topics that has preoccupied economists (including those at the OECD) for decades. The best available evidence is:

1)For most men, the level of benefits relative to earnings does not seem to have much effect on whether they search for work or not. This is presumably because ‘work’ is what men are expected to do – failure to work leads to loss of social status. The levels of income in and out of work only have a minor effect.

2)Women, and some groups of men (young adults, those approaching retirement) appear to be more responsive to differences in benefit income and earnings. The higher the replacement rate, the less likely are people to work.

3)However, looking at individual behaviour may not be enough.
Many economists believe that benefit levels affect the whole structure of the economy. This is because they think that employers choose how many workers they will employ according to how much they cost. The cost of workers depends on their wages (as well as employers’social contributions).

The more that workers seek higher wages, the fewer of them will be employed. The choice about whether to go for higher wages depends on how much money they might lose were they to be one of the unlucky ones who lost their jobs as a result.
And how much money they lose by becoming employed is measured by the replacement rate the higher the replacement rate, the less the financial cost of losing a job, and so the more likely are workers to bid for higher wages.

However, in interpreting replacement rates, it is always important to bear in mind that there are other things which governments can do to ensure that people work, even when replacement rates are high. Examples are: enforcing requirements to look for work, investing in quality education and training, and in general ensuring that the labour market is dynamic and creating lots of jobs. Countries that have high replacement rates, but low unemployment rates because they do these other things well, include the Nordic countries.