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How Is Unemployment Insurance Funded
USINFO | 2013-10-23 10:51
UI Taxes
The basic UI system is funded by taxes that employers pay on behalf of their employees. While technically employers pay both the federal and state taxes, economists generally regard the tax as falling on workers on the theory that the dollars employers pay in tax would otherwise go into workers’ paychecks.
States levy taxes on employers to finance regular UI benefits for unemployed workers (the federal government typically picks up the full tab for temporary emergency UI benefit programs such as EUC). The federal government also levies a UI tax on employers, under the Federal Unemployment Tax Act (FUTA), to finance the administration of state UI programs. This tax also supports the account that has been used to pay for extended weeks of benefits during most recessions,and the fund from which states can borrow when necessary to pay regular state UI benefits.
The federal tax is equal to 0.6 percent of the first $7,000 paid annually to each employee. This tax is regressive; because most workers earn more than $7,000 per year, they are effectively paying the same flat tax of $42 per year regardless of income. FUTA taxes thus represent a much smaller share of the wages of high-wage workers than low-wage workers.
If, in better economic times, federal trust fund balances grow large enough, the law stipulates that additional transfers be made automatically to the states. These “Reed Act” transfers (named after the 1954 legislation establishing this policy) go directly into state unemployment trust funds. States can use this money only for unemployment insurance but are not required to use it to improve or expand their UI benefits.
The state UI tax is not levied on the entire payroll of a firm, but rather on the first so-many dollars of each employee’s earnings; this amount is called the taxable wage base. The minimum taxable wage base that a state can use is $7,000 per employee. This minimum taxable base is by law the same as the taxable wage base for the federal UI tax and has not been increased since 1983. The median state taxable wage base in 2012 was $12,000.
An employer’s tax paid per employee is determined by the taxable wage base and the tax rate. Each employer’s tax rate is determined by its “experience rating,” which in turn is based on the employer’s history of laying off workers who then receive UI benefits. Businesses with higher layoff rates face a higher UI tax rate and thereby contribute more to the program that supports these workers than businesses that with lower layoff rates. On average, employers contributed $361 per worker to state UI programs in 2010 (less than 0.8 percent of total wages paid),but that amount varies greatly across states and among employers within states. Due to the caps on taxable earnings, the state unemployment insurance tax is, like the federal tax, regressive.
Solvency Issues
The U.S. unemployment insurance system was designed to be “forward funded.” That is, states are supposed to levy taxes on employers to build up balances in their UI trust funds during periods of healthy economic growth, and then draw down those balances to provide payments to unemployed workers during local or national economic downturns and recessions. Forward funding ensures that when recessions hit, unemployment payments will help sustain laid-off workers and their families, whose spending in turn will support the economy at a time when consumer demand is weak.
Rather than forward fund their programs, however, many states adopted a “pay-as-you-go” approach that held taxes artificially low when the economy was healthy instead of preparing for recession by building adequate trust fund reserves.
Though more than a decade had passed since the 1994 bipartisan advisory council appointed by President Clinton and congressional leaders urged states to return to forward financing, many states kept state UI taxes artificially low and by 2008 had actually reduced their UI tax rates to historically low levels.
Therefore, a number of states’ UI trust funds were inadequately prepared for the recession that began in December 2007, and most states had to borrow from the federal government to help pay benefits. Because unemployment is expected to remain high for some time, such borrowing will likely continue for the next few years.
States are required to fully repay the loans, with interest, within two years of borrowing the funds. If a state does not repay the full amount, the federal government will recoup its funds by effectively raising the federal tax on employers within the state each year until the loan is repaid. As a result, employers in 18 states and the Virgin Islands face higher FUTA tax rates for the 2012 tax year.
