Ifo Viewpoint No. 58: Hartz V

Hans-Werner Sinn
Munich, 08 November 2004

After Hartz IV there ought to come Hartz V, for, courageous as it may be, the reform does have shortcomings. Its greatest problem are the rules governing extra income for the future recipients of the new second-tier unemployment benefit (Arbeitslosengeld II). It is hardly worth it for them to take a job. Out of each gross additional euro they earn, as a rule they may not keep more than 20 cents – mostly only up to 15 cents.

Particularly affected are those unemployment benefit recipients who currently have a low-income side job. Hitherto they could earn 165 additional euros a month or more without being affected by a reduction in benefits. Under the new second-tier unemployment benefit rules, only 50 euros will henceforth be free. 85% of the additional income will be deducted from the benefits. Thus, a person earning 200 euros will keep only 73 euros, and another one who earns 400 euros would keep only 103 euros. Many of the unemployed will therefore give up their mini-jobs and try their luck in the underground jobs market.

The 85% to be deducted from benefits applies to incomes of up to 400 euros. Above that figure and up to 900 euros, the deduction from benefits and the marginal social security tax burden add up to an effective marginal tax rate of about 80%. For each euro in higher income, the effective marginal tax is around 90%. This applies to incomes all the way up to the limit under which the new second-tier unemployment benefit is to be paid, i.e. some 1200 euros for a single person and at least 1600 euros for married people or those with children, assuming typical housing subsidies.

The reduction in benefits constitutes for most an insurmountable obstacle to enter the labour market. This reduction gives rise to such high reservation wages that only very few jobs would turn out to be lucrative. For instance, an individual who requires a net income of 5 euros per hour in order to relinquish his leisure or underground job would need a gross wage of 33 euros in order to offer his services beyond the 50-euro free limit, and a wage of 25 euros in order to extend his work time beyond a 400-euro mini-job. Those earning 900 euros would need a 54-euro gross hourly wage for an additional work time. Non-single individuals choosing between unemployment and a job bringing in a 1600-euro gross wage need a 28-euro hourly wage in order to get 5 euros net per hour. Such high wage demands can hardly be met. Amongst employers, firms and private parties alike there are jobs aplenty, but no jobs which would be profitable at such wages.

This problem can be avoided by applying the Activating Social Aid model developed by the Ifo Institute. According to this model, free extra income of up to 400 euros is allowed; even more, the first 200 euros earned are topped up with a 20% supplement. Above 400 euros, the marginal burden resulting from reduction in benefits and taxes amounts to some 71%. Thus, a 200-euro job under this model brings a net income of 240 euro as opposed to the mere 73 euros under Hartz IV, while a 400- euro job leaves a net of 398 euros instead of the meagre 103 euros contemplated by Hartz IV. That translates into lower wage demands: for a 400-euro mini-job you need, in order to earn 5 euros net per hour, only 5 euros gross instead of 19 euros as with Hartz IV. Non-single individuals aiming for a 1,600-euro gross wage would demand an hourly wage of 10.70 euros instead of the 28 euros under Hartz IV in order to get a net wage of 5 euros per hour.

The lower wage demands will of course cause wages to decrease for those already in low-skilled employment. That cannot be avoided under any job-creating programme. Those claiming otherwise do not know what they are talking about. Under the Ifo model, this reduction in wages is compensated via the lower transfer deductions and the wage subsidy.

Despite the wage reductions and the lower rates contemplated in the new second-tier unemployment benefit, necessary to spare the state from additional expenditure, income of low-earners increases under the Ifo model. Adding together the wages earned, the wage subsidy and the social aid, they will have more money in their pockets than in the case of unemployment that Hartz IV really cannot reduce.

The politicians are attempting to tackle the problem of excessive wage demands with the so-called one-euro jobs: those who reject a suitable one-euro job may see their benefits reduced by 30% as a first step. Seen under this light, the possible income gain from working would be increased and the wage demand reduced. But it remains unclear which occupations are actually suitable in each particular case, how long these occupations have to be performed and how the competition with the private economy is to be avoided.

The Ifo Model avoids these pitfalls. The reduction in social aid if someone does not work is clearly regulated, so that no need for providing proof of suitability arises. At the same time, communities are obligated to provide temporary leasing jobs with private employers to all those who cannot find employment in the private economy. The individuals affected will receive a wage from the community amounting to the social aid they hitherto received, and the leasing job is set at a wage that would be interesting to the employers. The programme leads to full employment of low-skilled individuals, as there is a wage different from zero at which this interest can be aroused. The productivity of even the weakest member of society is greater than zero. Everyone is needed, whatever he can contribute with.

In terms of employment levels, national product, total income for low earners, performance of community jobs and, last but not least, legal certainty, the Ifo proposal is better than Hartz IV. There are no objections to using for it the name Hartz V, given that Hartz IV itself has more to do with the Ifo model than with the recommendations of the Hartz Commission.

Hans-Werner Sinn
Professor of Economics and Public Finance
President of the Ifo Institute

Published under the heading "Wenn sich Arbeit nicht mehr lohnt", Die Zeit, No. 46, November 4, 2004, p. 23.