Skill composition of migration and the generosity of the welfare state

Alon Cohen, Assaf Razin

Do generous welfare states attract less-skilled immigrants? This column says yes, arguing that previous studies, which yielded mixed answers, failed to distinguish between open immigration regimes and those restricting immigration on the basis of skills. Welfare state generosity is found to have a negative effect on the skill composition of immigrants under the free migration regime.

A number of European nations face a “demographic disaster” due to declining fertility. Might migration solve Europe’s population problem? Countries like Germany need both people and skills:

Germany's labour market is already facing skill shortages, which will intensify from 2010 when the postwar baby boomers enter retirement. When that happens, virtually all measures of economic dynamism, from gross domestic product per head to labour productivity, will plummet. As the working population shrinks and the number of pensioners rises, its welfare state, which dishes out €700bn a year in benefits to the elderly, the sick and the unemployed, will come under huge strain.1

But there are also fears that low-skilled immigrants may add to that fiscal burden. The idea that immigrants are attracted to the welfare state because of its benefits, in the form of social security, education, etc., is well known. A generous welfare program serves as a magnet to foreigners ("welfare migration").

Empirical evidence, addressing internal US migration, is inconclusive. Some support the welfare migration notion (Southwick 1981, Gramlich and Laren 1984, Blank 1988, Borjas 1999, Gelbach 2000, McKinnish 2005, 2007); others find no such evidence (Walker 1994, Levine and Zimmerman 1999).

International migration studies also exhibit mixed results. Pedersen at el. (2004) find that the tax-revenue-to-GDP ratio is negatively correlated with immigration flows from 129 countries of origin into 27 OECD countries. Peridy (2006), Leblang et al. (2007) and Warin and Svaton (2008) find positive effect of welfare-state benefits on immigration, from various countries into OECD countries. De Giorgi and Pellizzari (2006) examined the immigration into the EU from outside the EU, finding that immigrants are attracted to welfare, with no significant difference across skill levels. Docquier et al. (2006) explored immigration into OECD countries from 184 countries of origin. They find that low-skilled immigrants are motivated by welfare benefits much more than high-skilled immigrants. This indicates that even though the volume of immigrants increases with the generosity of the welfare state, their skill composition decreases.

None of these studies, however, distinguishes between the notion of "free migration" and "policy-controlled migration". Making such distinction, arguably, could explain the mixed results in the literature.

Free migration means that all individuals can freely move into the host country, reside, work and retire there. The EU is an example of such regime. EU members, in general, are obligated (by international treaties) to enable free entrance to any individual originated in other EU country.

Policy-controlled migration is exercised between any pair of countries that are not obligated to free migration. Immigration quotas are such a policy. Another sort, which becomes increasingly popular, is quality-selection migration policy. The host country screens out less desirable immigrants. Immigrants with high skills and education are preferred over immigrants with low skills and education. Quality-selection immigration policy is well established in Australia, New Zealand and Canada. The US also adopted such rules in 1990, as have a growing number of EU countries, including France, Ireland and the UK (Docquier and Marfouk 2006).

Why is such a distinction of crucial importance? In the case of free migration, equilibrium reflects the preferences and constraints of migrants in source countries (the "supply-side"). In the case of policy-controlled migration the equilibrium reflects the attitudes of policymakers in the host country (the "demand-side"). In order to examine the effect of welfare on the skill composition of immigrants, one therefore must separate between the "demand-side" (or more accurately, the "policy-side") and the "supply-side" effects, which are, in fact, operating in opposite directions. Failing to distinguish between these migration regimes may bias estimates of the effect of welfare state generosity on immigrants’ skill composition.

Theory

Consider first the supply-side effect, which accounts for the motivations of potential migrants in source countries. Generous benefits of the welfare state may increase the volume of migrants. However, while low-skilled individuals are attracted to a generous welfare state, high-skilled individuals may be deterred by such benefits.

A low-skilled immigrant opts for the country with generous benefits, as he or she is a net beneficiary of the tax-benefits scheme. As a net contributor to the tax-benefits scheme, a high-skilled immigrant will likely opt for the country with moderate benefits. Hence, the skill composition of immigrants, in equilibrium, is adversely affected by the welfare generosity of host countries (see Figure 1).

Figure 1. Supply side – welfare benefits and immigrants’ skills

Consider now the determination of immigration policy in the host country – the so-called "demand-side". Assume that policymakers represent the interests of their voters. Generous welfare states require high taxes, imposing a fiscal burden on the high-skilled workers of the host country. Therefore, the domestic low- and high-skilled voters support the admission of additional immigrants on a skill-selection basis, which mitigates the fiscal burden. Indeed, although high-skilled workers’ wages may be depressed by such a policy, domestic low-skilled workers support a maximum admission of high-skilled immigrants. Therefore, the skill composition of immigrants, in equilibrium, is (weakly) positively affected by the welfare generosity of host countries (see Figure 2).

Figure 2. Demand side – welfare benefits and immigrants’ skills

Clearly, this simple intuition exhibits opposite effects of the welfare state on the skill composition of immigrants. Our underlying assumption is that different migration regimes are dominated by different effects. The "free migration" regime enables each person free entrance to the host country. Therefore, the political considerations of the host country are irrelevant. Thus one can expect the considerations of the potential immigrants to dominate. The "policy-controlled" regime can be construed as determining simple quotas for differently skilled immigrants. Therefore the considerations of the immigrants are irrelevant. Thus one can expect the considerations of the host country to dominate.

Consequently, welfare state policy should have a negative effect on the skill composition of immigrants under the free migration regime. On the other hand, welfare state policy should have a (weak) positive effect on the skill composition of immigrants under the policy-controlled regime.

Empirical evidence

We confront the predictions of the theory with cross-sectional data of source-host developed country pairs. We decompose the data into two groups. Group A contains only source-host pairs of countries that allow free mobility of labour between them. Any kind of discrimination between native-born and immigrants, regarding labour market accessibility and welfare-state benefits eligibility, is prohibited. These are 16 European countries: Austria, Belgium, Denmark, Finland, France, Germany, Greece, Ireland, Italy, Netherlands, Portugal, Spain, Sweden, UK, Norway and Switzerland.

Group B includes only source-host pairs of countries within which the source country residents cannot freely move, work and get benefits in either of the host countries. The host countries are the same 16 countries as in group A. The source countries are 10 developed countries: US, Canada, Japan, Australia, New Zealand, Israel, Taiwan, Hong Kong, Korea and Singapore.

This decomposition is vital to the identification strategy. It embodies our threefold identification assumptions:

Immigration within group A is free, which identifies the effect of welfare on the considerations of the potential immigrants (the "supply-side effect"). Immigration within group B is controlled by policies of the host countries. This assumption identifies the effect of welfare on the considerations of the host country (the "demand/policy-side effect"). The decomposition into groups A and B is exogenous to the skill composition of immigrants. This assumption relies on the fact that this categorising, in fact, reflects the history of the EU establishment, since the post-WWII treaties. It is safe to assume that these agreements were not signed with regard to the skill composition of their future immigrants. Hence, the difference between the estimated parameter within group A and group B can also be identified.

We use the international immigration dataset introduced by Docquier and Marfouk (2006). It contains stocks of immigrants by the year 2000, based on census and register data. Immigrants are at working age (25+), defined as foreign-born, subdivided into three classes of education level: low (0-8 schooling years), medium (9-12 schooling years) and high (13+ schooling years).

Data for welfare-state benefits per capita is based on the OECD's Analytical Database. Social benefits encompass all kinds of social public expenditures, in cash or in kind, including old age transfers, incapacity related benefits, health care, unemployment compensations and so on. The data is PPP-converted to 1990 US dollars. We use lagged average rates for 1974-1990.

We neutralise any country fixed-effect by using skill differences estimation. We also neutralise any time-invariant omitted variables, by controlling for past migration stocks (in 1990).

Our findings match the predictions of the theory. We observe a negative and significant impact of the welfare-state benefits over the skill composition of immigrants, when estimation is restricted to group A. We also observe that the effect of welfare is significantly higher in group B, but not significantly different than zero. These results repeat in several estimations, either with high- versus low-skilled, or, with medium- versus low-skilled. It is also robust to different specifications of control variables. The instrumental variables estimation, using legal origin of the host countries as IV, further validates these results.

The distinction between “free migration” and “policy-controlled” regimes may therefore explain the mixed results of previous studies of immigrants’ skill composition and the generosity of welfare state benefits. Welfare can be a migrant magnet, which may be an important consideration for European policymakers addressing their coming demographic and skill shortages.

References

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1 Bertrand Benoit, “One of Us,” Financial Times, 21 June 2008