Funding for Unemployment Insurance

by John Berglund - John.Berglund@state.mn.us
January 2009

The unemployment insurance trust funds contain the states’ monies that are collected from employers and used to pay benefits to qualifying applicants. Within four months 15 states’ trust funds will be headed for insolvency or be insolvent. The current recession, which began in December 2007, is certainly partly at fault. Why is this downturn so different from earlier recessions where fewer states became insolvent?

The excellent article by Jennifer Steinhauer, “States’ Funds for Jobless Are Drying Up,” in the December 15, 2008, edition of The New York Times brought attention to a problem that has been festering for months if not years. Data supplied to Ms. Steinhauer by the National Association of State Workforce Agencies (NASWA) indicate that some 34 states are at risk of insolvency of their unemployment insurance trust funds within a year.

The recession may simply be the final straw, but it cannot be accused of being the sole cause. Factors such as state laws and administrative policies also play an important role. Moreover, the relatively weak expansion since the prior recession of 2001 has contributed to the weak financial condition of many states’ trust funds coming into the current recession.

The principle of unemployment insurance (UI) in the broadest sense is to provide partial income payments to help support an individual who is unemployed through no fault of his or her own. The payments (benefits) are based on the recent work and earnings of the unemployed applicants. Except in rare cases, the unemployed individual must have worked in employment covered by UI within the past 18 to 24 months in order to be eligible to receive UI payments.

UI is not a welfare program; it is a social insurance program. Social insurance, like private insurance, spreads the risk across a wide group called the risk pool. In the case of UI the risk pool for each state is the employers covered by that state’s UI law and their employees. UI premiums, euphemistically called contributions, are taxes collected from employers as a percentage of a base level of employee wages. The amount to be taxed, called the tax base, is set by each state and is applied per employee. In Minnesota this tax base is 60 percent of the average annual wage earned by all covered employees during the previous year. Each employer must pay taxes on the wages of each employee up to the base level even if the employee works for several employers at the same time.

These taxes are pooled and set aside to pay benefits to former employees when involuntary job loss occurs. Each state has its own trust fund account in the UI Trust Fund in the U.S. Treasury. In Minnesota the tax rate, or the percentage of the tax base paid by the employer for each employee, is determined by dividing the employer’s charges for job loss payments to former employees by the employer’s total payroll, each averaged over the previous four years. This figure is the employer’s experience rate that is added to the base rate assigned to all employers regardless of previous claims filed against them. Some form of experience rating based on the relation of previous job-loss payments to previous taxes collected is required by the federal government.

There are two sides to the trust-fund-flow picture, tax revenues coming in and benefit payments going out. Each side has several components that can affect solvency. Tax revenues, for example, are affected by states’ taxation policies. The amount of the payroll base on which taxes are charged, the tax rates assigned, the method by which experience rates are calculated, and the way the state regains payments that cannot be charged back to employers (e.g., payments for out-of-business firms) are all based on the individual state’s law and administrative policies.

On Jan. 1, 1983, the federal tax base for the Federal Unemployment Tax Act (FUTA) was raised from $6,000 to $7,000. Every state is required to have a tax base equal to the federal base; states may, at their discretion, set their tax base higher than the FUTA base. States whose UI laws stipulate that the state base equals the FUTA base will thus only raise the base if the FUTA base increases. The FUTA tax base has not increased in 26 years.

Table 1 shows, for each of the 34 at-risk states, the proportion of the tax base to the average annual wage of employees covered by unemployment insurance in 1983 and 2008 using 2007 average annual wages because the 2008 average annual wages are not available until July 2009. A smaller proportion of total payroll is subject to UI tax in 2008 than it was in 1983 for most of these 34 states. Minnesota, Idaho, Iowa, Nevada, New Jersey, and North Dakota are exceptions, with the proportion in 2008 actually higher than in 1983. Table 1 also includes what the corresponding tax base would have been in each of the 34 states if the 1983 proportions of taxable wage base to average weekly wage had been maintained. Minnesota, Iowa, and North Dakota are among the states that have tax bases greater in 2008 than their 1983 proportions dictated.

The states that have maintained the same tax base since 1983 are Alabama, California, Indiana, Kentucky, Louisiana, South Carolina, Tennessee, and West Virginia. Two of these states, Indiana and South Carolina, have recently been in the news because they had to borrow to continue to pay UI benefits. Michigan, the third state that has borrowed, also has a low tax-base-to-average-annual-wages ratio even though its tax base is $9,000. Alabama, Kentucky, and West Virginia all have the same base that they had in 1983 — $8,000. The remaining states that have the same base as in 1983 all use $7,000, the FUTA base.

A tax policy that fails to adjust its tax base with increasing wage levels is only one of the problems on the revenue side of the issue. If states do not have a fair way to collect on obligations not charged back to a specific employer (out-of-business firms, for example), the employers who have a tax levied against them must absorb the additional cost of these nonchargeable benefit payments.

In 1983 only three states had 0.0 percent rates assigned to some of their employers. Several other states had rates assigned that were less than 0.1 percent. On a $7,000 tax base the 0.1 percent rate would bring in $7 per employee for each employer assigned the minimum rate. In states where some employers had no UI tax obligation, nonchargeable benefits were absorbed by those employers whose rate was greater than zero.

In 2008 eight states assigned a zero rate to some of their employers. This matters because a zero-rate policy shifts costs from all employers (the insurance principle of everyone assuming some of the risk) to only those employers who have some charges (nonzero-rate employers absorbing the additional burden of noncharges). [1]

State laws and policies dictate how tax tables or schedules are set and used, depending on measures unique to each state. In Minnesota, for example, experience rates are calculated by dividing benefits paid by taxable payrolls. The calculated experience rates vary from 0.0 to 8.90 percent and are added to the state’s base rate. Other states may use a series of tax rate tables or schedules with some relation to either trust fund balances or to average experience rates to determine which tax schedule they will use in a particular year. Because of the way their experience rates are calculated, some states take longer for periods of high benefit payouts to be reflected in the tax structure.

Aspects of benefit payments — the maximum weekly benefit amount and the maximum length of time benefits may be received — affect revenues. Table 2 shows how these affect solvency. The total maximum benefit to which an individual is entitled, per claim year, is determined by multiplying the individual’s weekly benefit amount by the maximum number of weeks that full benefits may be collected. This maximum benefit entitlement can be thought of as a level of risk exposure. Since insurance doesn’t assume that all the insured will suffer loss simultaneously, the insurer can assess a premium related to the risk exposure and build reserves to replenish losses. In Table 2 the 1983 maximum benefit amount was calculated as a proportion of the 1983 taxable wage base. For the same 1983 proportion of the tax base to be in place in 2008, the tax base would have to increase in most of the 34 states.

A final problem of revenue received versus benefits paid is the timing of revenue collections. The states with lower taxable wage bases receive more of their revenues in April when taxes are due for wages paid in the January-to-March quarter since many employees’ wages reach the tax base during the first quarter. States with higher taxable wage bases get a little more with the taxes due for the second calendar quarter since many employees’ wages don’t reach the tax base until sometime in the second quarter.

If revenues in April exceed projected benefits paid, there is no problem. However, if projected benefits paid exceed revenue, the tax rates for the current year are already set. It will be the second calendar quarter of the following year before revenue received can again be applied against past, present, and future benefit charges. In the meantime any shortfall must come out of the state’s UI trust fund reserves.

Some argue that it is better for employers to retain the money as working capital rather than having it languish in the UI Trust Fund in the U.S. Treasury earning interest. If all parties to the discussion agree that a large trust fund should not be built up, these same parties also need to agree on a mechanism to replenish the trust fund quickly when expenses exceed income. When states get into a position where they must borrow from the trust fund, the federal government takes action to make sure the money is repaid. This involves increasing the flat, nonexperience-rated amount that all employers must pay to FUTA. Many employers consider this flat tax onerous. It gets much worse, however, when a state is not able to repay its obligation to the UI Trust Fund quickly. Employers, UI advisory councils, legislatures, governors, and any other interested parties have a hand in UI legislation, and all are responsible for the laws and policies enacted. There is no free lunch — pay now or pay later.

[ 1]Significant Provisions of States Unemployment Insurance Laws, U.S. Department of Labor, Employment and Training Administration