Responding to the need to promote efficiency-enhancing changes in the labor market, China has been experimenting with an unemployment insurance (UI) program over the last two decades. This paper reviews recent labor market developments, describes the evolution of the UI program, and assesses the working of the UI program by analyzing its coverage, level of benefits, work incentives, provision of employment services, and financial performance.

Among others, the paper uses UI program simulations for the Qingdao and Tianjin municipalities, and analyzes survival in unemployment of UI beneficiaries using individual level data from Qingdao. The paper finds that the current “no frills” program - the program that offers modest, yet important, protection against lost earnings while minimizing (re)employment disincentives - works reasonably well and fits the current stage of development of the Chinese economy.

The paper concludes by identifying key challenges of the program and exploring possible policy responses to these challenges in both the short- and long-term.

INTRODUCTION
The unemployment insurance (UI) system in China has undergone a significant transformation over the past two decades. When China first introduced such a system in 1986, it differed considerably from those in most other countries.

At that time, the Chinese system provided income and other support to redundant workers through their former employers, the state-owned enterprises (SOEs). Welfare of workers was considered to be the responsibility of SOEs, and therefore workers were not required to pay contributions.

As subsequent economic reforms ended the requirement that SOEs take care of their former workers, the UI system was modified accordingly. By 1999, when the latest UI guidelines were introduced, the features of the Chinese system had become much more similar to those found in other countries. The current system aims to provide a basic level of income protection to the unemployed as well as help them gain new employment through related active labor market programs.

Under increasing pressure to provide support to a larger number of workers, the UI system now faces a number of important policy dilemmas and challenges. The level of benefits remains quite low and provides a much lower income replacement rate than other countries.

For educated and more capable workers who have easier access to jobs, the fast growth of the economy therefore provides an equally or even more important type of insurance than the UI program. The improved financial situation of the UI program has raised questions about how the program should be financed and how the surplus funds should be utilized, while in many areas of the country, enforcement in collecting contributions and determining benefits eligibility has been weak.

Questions have also been raised regarding the possibility of extending coverage to rural and informal sector workers, the extent to which “hidden employment” of beneficiaries working in the informal sector should be addressed, and the effectiveness of accompanying active labor market programs.

The objective of this policy note is to assist the Chinese government in assessing implementation of the UI program to date, identifying key challenges, and exploring possible policy responses. The note begins with a background section on recent developments in the country’s economy and labor market and briefly describes the evolution of the UI program within this context. The note then provides an overview and analysis of the current UI program, touching upon critical issues such as coverage, benefit levels, effects on work incentives, provision of employment services, and financial performance.

For this analysis, the note draws upon results from recent UI policy simulation pilots in Qingdao and Tianjin; lessons from a World Bank-supported UI technical assistance project in Liaoning province; interviews with government officials involved in UI; and various UI-related studies and project reports. The note concludes with policy recommendations and suggests some future directions for UI system reform.

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Milan Vodopivec and Minna Hahn Tong
July 2008

TABLE OF CONTENTS
1. INTRODUCTION ............................................................................................................................1
2. BACKGROUND ...............................................................................................................................2
2.1 Recent Labor Market Developments...........................................................................................2
2.2 Evolution of the UI Program.......................................................................................................6
3. DESCRIPTION AND ANALYSIS OF THE CURRENT SYSTEM .................................................8
3.1 Current Design of the UI Program ..............................................................................................8
3.2 Key Issues Faced by the UI System.......................................................................................... 11
4. IMPROVING THE UI PROGRAM: POLICY CHALLENGES ....................................................21
4.1. Conceptual Framework of Unemployment Insurance ..........................................................22
4.2 Key Policy Challenges ...............................................................................................................25
5. CONCLUDING REMARKS..........................................................................................................39
Appendix 1: How recipients of unemployment benefit exit from unemployment – evidence from
Qingdao municipality UI program..........................................................................................................43
Appendix 2: Simulations of unemployment insurance program of Tianjin municipality .......................48

CONCLUDING REMARKS
Responding to the need to promote efficiency-enhancing changes in a labor market which created massive worker redundancies and dislocations, China has been experimenting with its unemployment insurance system in the last two decades.

The system prevailing since 1999 has worked reasonably well: the current “no frills” system offers modest, yet important, protection against lost earnings while minimizing (re)employment disincentives. By exceeding the minimum subsistence level, the benefits do maintain the basic living standard of the unemployed. Due to weak enforcement, the unemployed typically collect UI benefits for the maximum duration and many of them are simultaneously working in the informal economy, thus topping up the benefits with occasional earnings.

However, the same features of the model—parsimony and weak monitoring of informal employment—can also be credited for leaving reemployment incentives virtually unchanged. Lax monitoring does not prevent recipients from taking occasional jobs, and the low level of benefits poses little hindrance to taking regular jobs.

While the system seems to work reasonably well and fits the current stage of development of the Chinese economy, it could be improved in several ways. In the short term, these measures would include: more rigorous enforcement of contribution collection and awareness raising to increase UI program coverage; raising the level of benefits to ensure more adequate income protection; improving information systems as well as introducing specific operational guidelines about the enforcement of eligibility requirements to reduce leakages in the UI system; and improving the link to active labor market programs to improve incentives to maintain labor market attachment. The introduction of these measures, combined by improved pooling of resources, should also help ensure the continued financial sustainability of the UI system.

In the medium and long term, the policy challenges are even more demanding and complex. Expanding UI coverage may require the introduction of subsidized, defined contribution-based individual savings accounts, with the possibility of joint coverage of old age income support, disability, survivorship, as well as unemployment.

Improving the consumption smoothing properties of the UI system will almost certainly require the transition from a flat rate benefit to a benefit which replaces a certain percentage of individual’s earnings, which will be even more important if the current unprecedented high growth period of the Chinese economy comes to an end.

More sophisticated ways of reducing leakages of the UI system will also need to be explored, for example by introducing a system combining self- and social insurance, linking information systems on formal employment and cash benefits, and improving enforcement of initial and continuing eligibility requirements.

Finally, UI benefits will have to be better coordinated with other cash benefits, above all with severance pay and social assistance.

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