### Key proposals

• Federal financing: Address chronic underfunding and incentives to reduce outlays at the expense of workers by paying for all regular and extended UI benefits with federal dollars. Absent a switch to a wholly federally financed system, reform tax rate calculations and state trust fund targets to strengthen support for workers and stabilize the system.
• Taxable wage base: To make UI’s finances fairer and more efficient, broaden the taxable wage base for unemployment insurance to be equal to the wage base for Social Security.
• Tax rate: In a federally financed system, reduce employer incentives to block worker claims by reforming “experience rating” to determine the employer tax rate based on changes in hours employees work, not unemployment insurance claims. In a federal–state financing system, reconsider “experience rating” and base state trust fund targets on industry-adjusted per capita targets, not “high cost multiple” systems that encourage states to slash awards to replenish trust fund accounts.
• Recessions: In a federally financed system, acknowledge the economy-boosting benefits of unemployment insurance benefits during recessions by paying for them with general revenue. In a federal–state financing system, use automatic triggers to provide federal financial assistance to states.
• Classification of workers: Require states to implement “ABC” tests that prevent employers from circumventing taxes by reclassifying employees as contractors, and require large businesses that use a lot of contractors to pay unemployment insurance tax on their contractors.

## Introduction

### The problem

States and the federal government jointly finance unemployment insurance (UI) in the United States through state and federal taxes imposed on wages and paid by employers, with a portion of those taxes likely passed through to workers in the form of lower pay. During normal economic times, states pay for the benefits their workers receive, and the federal government provides grants to pay for the cost of administering the program. The federal government also finances 50% of the Extended Benefits (EB) program.1 In recent recessions, it has paid 100% of EB costs as well as the costs for additional non-EB benefit extensions.

The way we pay for unemployment insurance benefits explains many of the program’s problems today. The desire to attract businesses and jobs puts pressure on states to keep their tax rates low. To do so, they limit benefits recipiency (the share of unemployed workers receiving benefits), decrease the amount of benefits workers receive, or both. Employers also have an incentive to make it harder for workers to claim benefits—for example, by filing challenges and appeals to worker claims—because the UI taxes firms pay rise when their workers collect UI benefits, a structure known as “experience rating.”

For both employers and states, pressure to reduce the benefits flowing to workers is especially intense when benefits are needed most: during and just after major recessions. When profit margins are slim, employers may be more likely to try to save money by keeping their UI tax rate as low as possible.

Federal law requires states to save their UI funds in a trust fund account and encourages them to keep adequate funds in it. During past recessions, these accounts have run empty in a number of states. To refill their accounts and get back into balance, many states slash benefits. In the wake of the Great Recession, for example, nine states cut the number of weeks individuals could get benefits from the traditional 26 to as few as 12 (Leachman 2015).2 As of April 2021, state legislators in at least three states (Iowa, Louisiana, and Tennessee) had proposed cutting the benefit duration to 12 weeks in response to low trust fund balances following the economic crisis caused by the COVID-19 pandemic (Golshan and Delaney 2021). The consequences of inadequate program financing fall squarely on the most disadvantaged workers, disproportionately affecting communities of color, as described in Section 3, covering eligibility.

### The solution

Current financing of the UI system incentivizes employers and states to obstruct the delivery of UI benefits. Redesigning the way benefits are financed could create a system that would more effectively deliver UI.

### Implementation

Financing UI benefits at the federal, rather than the state, level is the most logical way to ensure adequate funding for and the equitable distribution of UI benefits. If policymakers choose to leave benefit financing primarily to the states, however, significant improvements could still be made.

Federal policymakers could approximate “first-best” reforms by (a) raising the federal taxable wage base (which would require states to raise their own taxable wage bases), (b) reforming experience rating, (c) making federal financial assistance to states for funding UI benefits more predictable by tying it to automatic triggers, (d) ensuring that firms do not have incentives to outsource or misclassify workers as contractors, and (e) basing state trust fund targets on industry-adjusted per capita targets, not the current “high cost multiple” system, which encourages tax and benefit cuts.

## Funding unemployment benefits with federal financing

In normal economic times, state UI benefits are the only support available to unemployed workers; during economic crises, they are often the only support preventing workers from falling into distress. But rather than ensure that these benefits are adequate, states compete in a race to the bottom, in an effort to attract firms. Employers shift production and workers to low-tax states (Guo 2020). They are especially likely to exploit differences across states in the taxation of part-time workers (U.S. GAO 1993). These moves hurt women, who are disproportionately likely to work part time, and people of color, who are disproportionately likely to work part time but want full-time work (Golden and Kim 2020).

Cutting taxes requires cutting benefits, making the race to the bottom evident in every aspect of the UI system (Galle 2019). After the 2009 recession, 10 states dramatically cut the duration of their UI benefits, and others failed to adjust the maximum benefit level for inflation for more than a decade, eroding benefits (CRS 2019; Smith, Wilson, and Bivens 2014). States that have most aggressively courted business by cutting benefits the most are also those states granting UI benefits to lower shares of separated workers (Desilver 2020; U.S. DOL-ETA 2021a; U.S. Census Bureau 2019). Indeed, historical data on the recipiency rate suggest that states tightening requirements in times of economic distress have contributed to subsequent declines in recipiency rates that have never ascended back to mid-last century highs exceeding 50%, and hover around 28% today (as of 2019) (U.S. DOL-ETA 2021b). By capitulating to employer threats to move jobs out of state, local officials may see themselves as winning a competition with their neighbors. But the result is a less effective automatic stabilizer to assist displaced workers during recessions, leaving the federal government holding the bag to pay for other safety-net programs.

### Policy proposal: Fund regular unemployment benefits and the full cost of extended benefits with federal financing

No solution short of federal financing will fully overcome these problems; if states can compete with one another to lower taxes, they will. If their revenue is lower, they will find new ways to reduce recipiency rates. Following the Great Recession, for example, when federal law temporarily constrained states from reducing benefit amounts, they cut the duration of benefits (CRS 2019; Smith, Wilson, and Bivens 2014). Some states also erected new administrative barriers (Wentworth 2017). For example, a new online system in Massachusetts increased one form of benefit denial by 950%, and delayed claims processing by more than six weeks on average. Florida increased one category of procedural denials by 180%, and another by 400%.

Financing at least the cost of the minimum regular UI benefits we have described with federal money—building on the existing federal financing of program administration and extended benefits—could eliminate this race to the bottom.3 Removing this competition would remove the greatest barrier to adequate benefit financing.4 A federally financed regular UI benefit could be financed in several ways, as shown below.

## Increasing the taxable wage base

Currently, states and the federal government finance UI almost exclusively through taxes on employers. The total tax an employer owes is based on the product of its tax rate and the taxable wage base, the portion of each employee’s salary that is considered when calculating the tax owed. For the current federal UI tax—the Federal Unemployment Tax Act (FUTA) tax—the federal government taxes only the first $7,000 of each employee’s wages. State wage bases cannot be lower than the federal wage base; they currently range from$7,000 to about $53,000, with most of them less than$15,000 (U.S. DOL-ETA 2020c). The taxable maximums for UI wage bases are far lower than the taxable maximum wage bases for other programs. For example, the wage cap for the Social Security portion of the Federal Insurance Contributions Act (FICA) for 2021 was $142,800. The UI federal wage base has failed to keep up with inflation; it was$3,000 in 1939, or more than $55,000 in 2021 dollars, almost eight times its current value of$7,000 (Gould-Werth 2020a).

### Policy proposal: Set the taxable wage base for unemployment insurance equal to the wage base for Social Security

We propose increasing the federal UI taxable wage base to a level equal to the current Social Security taxable wage base and indexing it to inflation. Raising the wage base threshold would allow for much lower rates, which would be more economically efficient, because they would reduce the incentive to attempt to avoid the tax. If UI financing were shifted to the federal level and the taxable federal wage base broadened, revenues could increase without an accompanying rate hike.

A higher wage base cap would also better align the constituencies that pay the tax and draw benefits from it. For example, a worker in Vermont who earns $10,000 a year has taxes levied on 100% of her wages and has 100% of her wages considered when setting benefits, whereas a worker who earns$50,000 has taxes levied on only 28% of her earnings, but has 92% of her wages used when determining her benefit level (U.S. DOL-ETA 2020b; Vermont DOL 2021). Such a system thus imposes a greater relative burden on the lower-wage worker.

## Endnotes

1. According to the U.S. Department of Labor, “Extended Benefits are available to workers who have exhausted regular unemployment insurance benefits during periods of high unemployment. The basic Extended Benefits program provides up to 13 additional weeks of benefits when a State is experiencing high unemployment. Some States have also enacted a voluntary program to pay up to seven additional weeks (20 weeks maximum) of Extended Benefits during periods of extremely high unemployment. Extended Benefits may start after an individual exhausts other unemployment insurance benefits (not including Disaster Unemployment Assistance or Trade Readjustment Allowances). Not everyone who qualified for regular benefits qualifies for Extended Benefits…. The weekly benefit amount of Extended Benefits is the same as the individual received for regular unemployment compensation. The total amount of Extended Benefits that an individual could receive may be fewer than 13 weeks (or fewer than 20 weeks).” U.S. DOL-ETA 2021c.

2. The states were Arkansas, Florida, Georgia, Illinois, Kansas, Michigan, Missouri, North Carolina, and South Carolina.

3. We do not mean to rule out the possibility that states would voluntarily impose their own taxes to pay for benefits more expansive than those we propose. Added benefits might also be fully or partially federally funded.

4. If the taxable wage base were raised, workers in high-wage states would cost their employers more in UI taxes than workers in low-wage states. But equal tax rates would ensure that this difference was driven by labor costs, not taxes. The marginal dollar of salary would cost the same no matter what state it was paid in.

5. The other side of this argument is that raising the cap could discourage pay raises and potentially full-time work. In many jurisdictions, the cap is now so low that it is effectively a fixed tax per employee, leaving employers indifferent to wage levels. (For a summary of the evidence that rated taxes affect only the “extensive,” or hiring, margin, see Guo and Johnston 2020.) With a higher cap, pay raises potentially lead to a UI tax increase. Depending on other UI rules, this principle can also translate into a preference for part-time employees: Once it is no longer advantageous to hire one $40,000 salary worker instead of two$20,000 salary workers, an employer might split a single position into two, perhaps to take advantage of other provisions that turn on full-time versus part-time status (Guo and Johnston 2020).

6. If states continue to pay UI benefits through state trust funds, expanding the wage base could help strengthen state finances (ACUC 1996; Vroman et al. 2017). Although states could cut rates in response to an expansion of their wage base, analysts predict that many states would still bring in additional revenue on net (CBO 2012).

7. The full federal rate is 6%, but it is reduced to 0.6% in states that are in compliance with federal law. The Department of Labor has never found a state to be so out of compliance, so the 6% rate has never been triggered.

8. Most states still use an antiquated variant (the “reserve ratio” method), in which long-standing employers can become insensitive at the margin to further changes in employment. Under this system, high-turnover firms are strongly incentivized to outsource work to contractors (Pavosevich 2020).

9. It does not appear that there are any strong reasons to encourage employers to challenge employee benefits. McLeod and Malcolmson (1989) argue that if employers are not rated based on their employees’ benefits, they will not be incentivized to share with government officials information that could indicate a fraudulent claim. We could not identify any evidence that this is the case. Moreover, fraud reduction is small compared with the direct impacts of experience rating. For example, recipiency rates vary dramatically between high- and low-recipiency states, with workers in high-recipiency states receiving benefits more than twice as often as workers in low- recipiency states (Desilver 2020). It is unlikely that differences in fraud detection explain a meaningful portion of these differences.

10. Our proposal builds on work by Vroman et al. (2017) and Miller and Pavosevich (2019). Miller and Pavosevich (2019) propose alternative systems modeled on Alaska’s payroll decline method. Vroman et al. (2017) conclude that none of the alternatives they modeled was clearly superior to the best options now in practice, but they did not consider the refinements Miller and Pavosevich propose, such as the use of the “average quarterly hours” measure we describe below.

11. Municipal and nonprofit employers often are not formally experience rated, but instead may opt to “self-insure,” which means that they pay into the system only when their employees claim benefits. Our proposal would therefore leave these employers with strong incentives to prefer lower benefits and to contest claims. It is likely all employers should be taxed by the same rules.

12. Although the use of average quarterly total hours—as Miller and Pavosevich (2019) propose—adds some complexity, it solves a key problem Vroman et al. (2017) identify. Consider a 10-worker firm that lays off all 10 workers in Q1 and rehires them in Q3. There is a 100% decline from Q1 to Q2 and an infinite percentage increase between Q2 and Q3. If the firm lays off and rehires only nine workers, there is a 90% reduction between Q1 and Q2 and a 900% increase between Q2 and Q3. Both these scenarios would produce highly inaccurate results for the rehiring employers. Using average total hours smooths these changes, so that in the second scenario, for instance, there is about a 130% reduction (9/[(10+1+10)]/3)) in the number of employees followed by a 130% increase. Applying the discount factor, W, to the increase would result in a net reduction in hours, reflecting the fact that the firm made some use of the UI system.

13. For small employers, the quarterly components could be weighted by the quarter’s total hours, a step that would tend to reduce the volatility of the measure (Vroman et al. 2017).

14. For example, suppose a state is projected to average $1 billion in UI spending during high-cost periods but it has only$750 million in its trust fund. A target AHCM of 90% would require the state to hold at least $900 million in its trust fund. If the state cuts benefits, its projected spending might fall to$800 million, allowing the target trust fund balance to be only \$720 million. The state has cut its way to its target.

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