What's driving the decline in labor force participation?

One of the distinctive features of the U.S. economy's current expansion phase is that it has been the weakest recovery ever. As the graph above shows, the economy is operating significantly below its long-term growth trend; if this were a typical expansion, the economy would have recovered to its trend growth path long ago. In fact, it's only grown at a 2.1% annualized pace from mid-2009 through mid-2014. Not only is growth slow, but the economy likely has a lot of unused capacity; because of that, national income today is arguably about $1.7 trillion less than what it could or should be. 

The next most distinctive feature of the current recovery is the unprecedented decline in the labor force participation rate, shown in the graph above. Beginning in 2009, some 7 million people of working age have dropped out of the labor force or given up looking for a job. But why? One standard answer is demographics—the baby boomer generation is starting to retire. But demographics don't turn on a dime, they take many years to play out. In contrast, the current and ongoing decline in the labor force participation rate started rather suddenly in 2009. 

It may be a coincidence, but there was a significant change in fiscal policy that occurred around 2009 that might explain the decline in the labor force participation rate: a huge increase in government transfer payments. As shown in the first of the two graphs above, transfer payments (social security, medicare, medicaid, unemployment insurance, food stamps, disability insurance, veterans benefits, subsidies) rose from 17.2% of disposable income in September, 2008, to 20.1% of disposable income by September, 2009. In dollar terms, annual transfer payments rose by $300 billion, almost 16%, in just one year. Since then they have largely kept pace with the growth of personal income, and they are now significantly higher relative to disposable income than ever before. In my book, this ranks as a significant change on the margin that negatively affected people's willingness to work.

With the government paying people more than ever not to work, it should not be surprising to see fewer people willing to work. As the graphs above show, the labor force participation rate began to decline just after transfer payments rose to a new all-time high of 20% of disposable income. In the past decade, transfer payments relative to disposable income have increased by fully one-third, with most of that increase coming in 2008 and 2009. It's worth noting that the economy has not experienced robust growth for at least a decade.

With the government being generous to a fault, many folks apparently have found it easier than ever before to "drop out." 

One reason transfer payments reached unprecedented levels in 2009 was the Emergency Unemployment Claims program that Congress passed in 2008. Never before could people receive unemployment insurance benefits for so long—up to 99 weeks and even more. This program alone accounted for a $90 billion increase in transfer payment spending in the 12 months ended September, 2009. Spending peaked shortly thereafter, however, then declined by a $100 billion annual rate between early 2010 and  the end of last year, when the program expired. It's not contributing to transfer payments any more, but nevertheless they have remained historically very high. One out of every five dollars that consumers have available to spend is coming from the government, with no requirement to work.

Another reason that transfer payments rose is the increase in the number of people receiving social security disability insurance since the end of 2008. The growth in the number of recipients has declined in recent years, however, and has been relatively flat for at least a year or so. There are about 11 million recipients of this benefit, which totals almost $1000 per month on average, bringing the total annual spending to about $130 billion, or just over 5% of total transfer payments. Nothing significant changed with this program in 2008 or 2009, however, with growth in the post-recession years substantially the same as before. So it's not the culprit many think it is.

A 15% increase in the monthly food stamp benefits in 2009, plus a relaxation of the eligibility rules in April 2009, helped fuel a huge, 50% increase in the number of people receiving food stamps since the end of 2008. The average SNAP recipient gets about $125/mo., and the program is currently costing about $70 billion per year. That equates to about 2.8% of current transfer payments. In 2009, the increased spending on food stamps in 2009, relative to 2008, was about 40%, or about $20 billion per year. Not a big factor, but certainly a contributing factor.

Another big reason for increased transfer payments was the ARRA, over 75% of which consisted of an increase in transfer payments, much of which, in turn, came in the form of tax benefits, housing assistance, grants, and expanded entitlements that likely continue to exist.

One more thing: marginal income tax rates have increased in recent years, by a not-insignificant amount, especially due to the implementation of Obamacare, which imposes a 3.8% tax on earned income and another 3.8% tax on unearned income for those considered to be "rich." I know people in California who now face marginal tax rates as high as 74%. That is a powerful disincentive to work.

And as Milton Friedman taught us, "spending is taxation." Every dollar of transfer payments from the government is a dollar that comes from the private sector. More transfer payments drain more resources from the productive sector, and thus contribute to slow the growth of jobs and incomes.

I wish I could identify all the pieces of this smoking gun, but I am reasonably convinced that a significant increase in government transfer payments, combined with higher marginal tax rates, have created, on the margin, important disincentives to work, and that, in turn, is an important driver of the ongoing decline in the labor force participation rate.