More than Cost Shifting: Moral Hazard Lowers Productivity

A substantial number of papers have shown that as workers’ compensation statutory benefits increase, reported claims frequency and severity also increase. While this seems to be a robust finding in the literature, it is not known how these moral hazard responses affect real productivity. Moral hazard is usually regarded as shifting costs from group health medical to workers’ compensation medical, or from absenteeism to workers’ compensation disability, with no real consequences on the output of firms. But moral hazard can reduce output in two ways: (1) in the misallocation of inputs due to "bad" cost information, or (2) in the loss of specific human capital, controlling for the allocation of other inputs. We employ two data sets to analyze the impact of the second effect, reduced manufacturing output due to the loss of specific human capital because of moral hazard. We find significant effects: a 10 percent increase in benefits leads to an estimated decrease in output, ranging from .3 to 4 percent, depending on specification. MORAL HAZARD AND WORKPLACE ABSENTEEISM Moral hazard arises whenever the difficult-to-monitor activities of workplace participants, who are protected by disability systems, increase the insurance liability of firms’ owners. The owners of profit-maximizing firms would like to write enforceable contracts that make the whole disability process "objective" in the sense that it provides only the appropriate level of medical care. Of course, such contracts are difficult and therefore costly to monitor. Hence, the costs of monitoring workers, administrators, and health care providers reduce the amount of monitoring that firms would undertake in a full information world. Those Richard J. Butler is the C. Arthur Williams, Jr. Professor of Insurance at the University of Minnesota, B. Delworth Gardner is Emeritus Professor of Economics at Brigham Young University, and Harold H. Gardner is Chairman and CEO of OCI. The authors are grateful for computing support from the Department of Economics at Brigham Young University and the Carlson School of Management at the University of Minnesota. They are also grateful for research assistance from Yong Sueng Park and Todd Hilbig. Useful comments were received on previous drafts at the University of Pennsylvania, Cornell University, the annual meeting of the American Risk and Insurance Association, and Journal of Risk and Insurance’s referees. 672 The Journal of Risk and Insurance participating in the disability process realize that this informational asymmetry exists and can turn the situation to their advantage. Moral hazard increases workplace absenteeism when such informational asymmetries are used to increase the frequency or duration of workers’ compensation claims. These additional claims are known as “moral hazard” because the costs of extra usage (above that in a full information world) are borne by all the workers and owners of the company indirectly through higher cost for health and insurance benefits (with offsetting reductions in wages and possibly company profitability), while the benefits are captured by individual participants. Unfortunately, since all face the same situation, individuals have some incentive to use the system more than they would have if they were paying with their own money, or if their behavior could be monitored without cost. Overwhelmingly, the extant literature indicates that workers respond to economic incentives provided by workers' compensation disability payments. In the absence of moral hazard, a change in benefits would not cause a systematic change in the claims. However, claim severity and frequency tend to increase as benefits increase and as the waiting period prior to the receipt of wage benefits (a de facto deductible) falls. Despite this evidence, the potential impact of moral hazard on real productivity has been ignored because moral hazard is primarily seen as a change in the incentive to report an accident, shifting costs from one type of employee benefit to another. For example, an employee may claim that a given condition arose from a job injury and seek workers' compensation benefits because their real health condition (broadly defined) does not qualify for short-term disability compensation. An extreme case of "claims reporting" moral hazard is overt fraud in which a worker facing a pending layoff claims injury benefits when no injury was incurred, either on or off the job. In both of these examples, employee claims shift costs: in To the extent that compensating wage differentials may be imperfect, there may also be reductions in employment. Workers’ compensation insurance provides benefits to workers for on-the-job injuries. These benefits include unlimited medical benefits, partial wage replacement benefits during the period of disability (which depend on whether the disability is temporary or permanent), and vocational rehabilitation. Individual states establish specific parameters for the wage replacement benefits. Typically, these indemnity benefits will equal two-thirds of the injured workers pre-tax weekly wages subject to a state minimum and maximum. Permanent injuries may be compensated based on the degree of wage loss by a "scheduled" amount for specific injuries, or by some combination of the two. Again, individual states establish their own specific parameters. Claim severity has been found to be positively correlated with benefits in studies employing individual insurance claim data (Worrall and Butler 1985; Butler and Worrall 1985; Currington 1994), in studies employing insurance data for individual firms (Butler and Worrall 1988), and studies using sample survey data (Johnson and Ondrich 1989; Johnson, Baldwin and Butler 1994). Claim frequency increases with higher benefits in studies using aggregate data (Butler 1983; Butler and Worrall 1983; Chelius 1982; Krueger and Burton 1990; Ruser 1985; Worrall and Appel 1982; Butler 1994), as well as those using microeconomic data (Leigh 1985; Krueger 1988; Ruser 1989; Hirsch, MacPherson and Dumond 1995). However, one disaggregated analysis, done by Moore and Viscusi (1988), find--contrary to the aggregate analysis by Butler (1983)--that a lower rate of fatal risk is associated with higher workers’ compensation benefits. Their study of fatal injuries may be picking up changes in real risk behavior and not measuring nominal or "claims-reporting" moral hazard. This is suggested in a simulation by Kneiser and Leeth (1989), and in empirical research by Ruser (1990) and Butler and Worrall (1991). More Than Cost Shifting 673 the first case, costs are shifted between group health/paid sick time and workers’ compensation medical/indemnity; and in the second case, costs are shifted between unemployment insurance and workers’ compensation indemnity. While such benefits-induced cost-shifting may not have much impact on real output, increased workplace absenteeism will lower output to the extent that the firm specific capital is important. As statutory benefits increase, absenteeism rises with a concomitant loss of firm specific capital. This loss in firm specific capital causes output to fall. While firm-specific capital can not be directly observed and estimated, the impact of lost firm-specific capital on output can be inferred indirectly. Since higher statutory benefits increase absenteeism (see prior research cited in footnote 3), evidence that higher statutory benefits also lower output provides indirect evidence on the importance of lost, firm-specific capital. This paper measures changes in output as statutory benefits rise by embedding the benefits replacement rate in a Cobb-Douglas production function. In the next section, prior research on the importance of firm specific capital is discussed. In the third section, the effect of higher disability pay on value-added in manufacturing, using an industry longitudinal sample, is estimated. In the next to the last section, the production model is estimated on a much larger longitudinal sample (state data), which allows for more variation in the benefits replacement rate, the key independent variable of interest in the analysis. Conclusions are drawn in the final section. MORAL HAZARD AND THE LOSS OF FIRM-SPECIFIC CAPITAL If moral hazard responses to disability insurance increase absenteeism, then real output will be reduced as firms lose specific human capital investments. Higher disability pay will lower firm productivity in two stages. In the first stage, real benefit increases can be expected to increase work-injury days. (Evidence for this first stage is cited in footnote 3.) In the second stage, the loss of firm-specific human capital induced by increased benefits lowers output. Researchers would like to observe directly how absenteeism affects workplace productivity, but the data do not allow us to do this. 4 Rather, the effects are estimated indirectly: by holding capital and number of workers constant, it is observed whether increases in lost work-time pay decrease output. This is the first study that examines the reduction in output resulting from potential firm-specific human capital losses from moral hazard responses to increases in benefits. Evidence on the importance of firm-specific capital comes both directly from evidence that job training enhances wage growth (Mincer 1988; Brown 1989) and indirectly from analyses of wage growth in longitudinal data sets (Topel 1991; Oliver et al. (1994) report that more productive workplaces have lower absenteeism, but make no attempt to model the relationship or demonstrate causality. The one earlier study of the relationship between benefits and productivity is Butler and Worrall (1993), which also presented estimates of the impact of benefits on value added by manufacturers. This paper differs from that in a number of ways: (1) the effect of benefits on productivity was not its main focus, (2) it did not explore the ramifications that firm-specific human capital might have for moral hazard responses, (3) it employed a different specification, and (4) it used different data. 674 The Journal of Risk and Insurance Becker and Lindsay 1994). These studies suggest that firm-specific tenure increases annual wage growth from 1.5 to 6 percent, depending upon the occupational group and age (blue collar workers in Topel’s sample exhibited wage growth of from 4 to 5 percent per year of firm-specific tenure). For an experienced labor force, the skill embodied in firm-specific human capital represents a substantial fraction of the productive value of the input. To model the effects of firm-specific capital on output, assume that "labor" is a homogeneous function of the number of workers and the total firm-specific capital of those workers. Newly hired workers are assumed to have already acquired the appropriate level of general human capital. "General" human capital is regarded as being applicable to all workplace environments and can be purchased in the market. However, since "specific" human capital results from investments made jointly by the firm and the worker in previous periods, the market does not produce it. Firmspecific capital is assumed to be fixed in the current period, and thus the employer chooses the amount of physical capital, the number of workers, and future firmspecific investments in human capital. In this simple model, moral hazard can reduce output in two ways: (1) in the loss of firm-specific human capital, controlling for capital and the number of workers, and (2) in the "misallocation of inputs," which includes all inefficiencies associated with allocating the "wrong" number of workers. Perhaps the simplest example of the second type of cost misallocation would be that higher benefits more than proportionately increase the costs of insurance (ignoring, for the moment, the potential for offsetting wage effects), thus raising the cost of hiring more workers. The firm would then react to the higher labor costs by increasing capital relative to the number of workers. Hence, moral hazard may change the capital/worker ratio of the firm. We do not attempt to measure this second class of resource misallocation in the empirical proportion of this paper. Rather, the impact that moral hazard responses have on real output through the reduction of firm-specific capital is examined. The bottom line is that even when the number of workers is held constant, the increased use of disability time induced by moral hazard responses will reduce the firm’s "effective" labor because of the loss of firm-specific human capital that cannot be purchased in the market and cannot be replaced in the short run. As a consequence, moral hazard responses will cause output to fall even after controlling for the number of workers and the amount of capital. The Topel and Becker-Lindsay studies both employ the Panel Study of Income Dynamics (PSID) for their analysis, as did early studies of the same issues by Abraham and Farber (1987) and Altonji and Shakotko (1987). We do not consider the results of these latter two studies as they apparently employed inconsistently reported market experience data that seriously biased their estimates of the returns to firm-specific experience (see Topel 1991). While investments can be made in the current period, we assume that those investments are small relative to the stock of firm-specific human capital that is required. In particular, it is assumed that the firm cannot fully train new employees in a single period. Another somewhat more subtle example of how firm-specific capital might be affected by moral hazard is through the investment profile offered by the firm. Higher workers’ compensation costs induced by moral hazard responses would likely produce larger and relatively unproductive investments in safety training, when, in fact, the real level of injury risk was much smaller than the moral hazard driven insurance data would indicate. Hence, there would be too great an emphasis on firmspecific More Than Cost Shifting 675 More formally, assume a simple production model in which output (Y) is a function of physical capital (K) and human capital (L):