Unemployment insurance: Employers shoveling in a deep hole

The onset of the Great Recession has given new status to unemployment insurance. Traditionally limited to 26 weeks of financial assistance for the jobless, it has been expanded numerous times of late to allow benefits for longer periods of time. Most recently, Congress decided in December to continue a tiered system—otherwise slated for sunset at year’s end—that pays benefits to some workers for up to 99 weeks.

The expansion of unemployment insurance (UI) has been widely popular because it strengthens the financial safety net for those who have lost work during an economic downturn unprecedented in many people’s lifetimes. But less recognized is the back-end effect of paying those benefits. Many people mistakenly believe UI benefits come from general state and federal government expenditures. But the majority of UI benefits are paid out of state UI trust funds, which are generated by a per-employee tax (euphemistically called a “contribution”) on businesses.

High unemployment means more workers are receiving UI benefits, and extensions mean workers are receiving benefits longer—44 percent of the nation’s unemployed last December had been out of work at least 27 weeks. Lower employment also means fewer people are paying into state trust funds, forcing some states to borrow heavily from the federal government to continue paying benefits.

Until employment rebounds, replenishing trust funds will probably mean raising UI taxes. Contribution rates in district states crept higher in 2010 and are likely to continue rising in coming years. But higher UI taxes could perpetuate unemployment by increasing business expenses and dampening hiring at a time when it’s desperately needed.

ABCs of UI

State-based UI programs all have the same goal of assisting the jobless, but each state’s program is unique because each state sets its own benefit levels and develops a contribution formula to fund necessary benefits.

Benefits can vary substantially among states. For example, the maximum weekly UI check in South Dakota is $309; it’s a little over $400 in Montana and about $575 in Minnesota. To generate appropriate funding, states set a taxable wage cap—in other words, the amount of employee wages subject to UI taxes. Last year in the Ninth District, the taxable wage cap ranged from a low of $10,000 in South Dakota to a high of $27,000 in Minnesota. Any income over those amounts is not taxed for unemployment insurance.

States then establish a contribution rate with a sliding scale—referred to as the experience rating—which is based on a firm’s employment history. Firms with a history of laying off workers (who then receive UI benefits) pay higher UI contribution rates per worker than firms with few or no layoffs. Depending on the state and a firm’s experience rating, annual contributions can run anywhere from zero for firms with very low turnover to a couple of thousand dollars per worker for firms with spotty employment records.

The trick for each state’s UI program is to maintain cash flow, taxing firms just enough to cover UI benefits for the jobless and tweaking contribution rates annually to keep trust funds stable as employment either rises or falls. But persistent high unemployment during and after the recession has blown holes in most state trust funds, including those in the Ninth District.

At the beginning of 2008, five district states had UI trust funds totaling almost $1.6 billion. As of this past January, that balance had fallen to $282 million, according to figures from the U.S. Treasury’s Bureau of the Public Debt. Minnesota’s trust fund balance plummeted from a little over $500 million in January 2009 to less than $10 million a year later (see Chart 1). South Dakota typically maintains a comparatively small UI trust fund—about $20 million to $25 million, in part because of a low taxable wage ceiling, relatively low benefits and an unemployment rate among the lowest in the country for years running. The fund fell from $25 million in January 2009 to just $1.2 million a year later, before recovering to previous levels thanks to a temporary UI surcharge on employers.

Large Chart

The drop in trust funds would be even greater if not for significant borrowing by several states from the federal government and injections of economic stimulus money to encourage states to offer benefit extensions. For example, South Dakota’s trust fund paid out $64 million in benefits in 2009 while taking in only $32 million, of which almost $6 million was stimulus funding.

The negative cash flow has been even more severe and prolonged in Minnesota and Wisconsin (see Chart 2), where benefit costs have skyrocketed and fund contributions have lagged. In 2010, for every dollar contributed to Minnesota’s trust fund, the state paid out $2.19 in benefits, according to an annual report from the U.S. Department of Labor. To remain solvent, both states have borrowed heavily from the federal government; at the start of this year, Wisconsin had borrowed a total of $1.4 billion, and Minnesota about $770 million. Yet despite the infusions, trust fund balances were negligible for each state at the start of this year.

Large Chart

Going up?

States will have a tough time replenishing their trust funds. Contributions would rise automatically if employment improved significantly, and benefit payments would decline if unemployment dropped. But most forecasts (including those of the Minneapolis Fed) do not expect dramatic changes in the near or intermediate future on either measure.

So states will be forced to support their UI trust funds with the only remaining tool at their disposal—higher contribution rates paid by employers for every worker on the payroll. States have raised UI contribution rates of late, and average contributions are on the rise (see Charts 3 and 4).

Large Chart

The near-term outlook for UI rates is not very positive for employers. Contribution rates tend to be cyclical, and lagging: Rates are generally low when the economy is doing well and unemployment is low; rates are high when the economy struggles and unemployment is high. But rates tend to lag unemployment trends because annual rates are set the previous year based on past experience. For example, rates in 2005 were higher than in 2007 because of sluggish job growth coming out of the 2001 recession.

So today’s rising rates shouldn’t be a surprise as states across the nation deal with high joblessness and trust funds remain under financial siege. And therein lies the catch-22 for the current UI system: While higher, extended benefits are a godsend to the unemployed, they also raise UI costs for employers, potentially slowing the engine of job creation and extending joblessness.

But not all UI programs are similarly designed, and the coming years should offer policymakers a unique window to optimal program design. For example, to replenish trust funds, many states increase costs across all experience ratings, which translates into incrementally higher UI costs for all businesses. That’s good for firms that have laid off workers (and subsequently receive benefits from now-depleted trust funds) but bad for firms that have retained and expanded their workforce, because they will share in the cost to rebuild trust funds.

Minnesota, however, computes experience ratings for individual firms based on their four-year layoff experience. That’s the simple reason that average contributions per worker have trended downward through 2010 (unlike most states; see Chart 4). When rates for 2010 were set in 2009, the previous four years (through 2008) were used, which included only a portion of the recession’s rise in unemployment.

Of course, that means Minnesota’s rates will be going up as the method’s timeframe catches up. But not for everyone, because only the rates of firms that laid off workers will be affected. Lee Nelson, director of legal affairs for the state’s trust fund, said 62 percent of employers statewide continue to pay the minimum UI rate (about $200 per worker) because they have not laid off any workers in four years.

Minnesota also sets a much higher maximum UI rate—about $3,000, the highest in the country—which means employers with a history of layoffs pay significantly more per worker, compared with similar firms in Montana and Wisconsin (up to $1,600 and $1,200, respectively).

“Minnesota’s rate is going to go up,” said Nelson. “But most [employers] won’t see an increase.”