The Administration’s New Plan to Revamp the Unemployment Insurance Tax: A Good Policy That Can Be Greatly Improved

According to information recently leaked to the press, the Obama administration is likely to propose an overhaul in the tax that pays for unemployment insurance (UI) benefits. The UI tax is a payroll tax imposed on employers and applied to the wages they pay their workers. The tax consists of two parts, one that finances the administration of the program and that goes to the federal government and a second that is set by state legislatures and pays for the first 26 weeks of (regular) UI benefits.

This financing system has proved inadequate to cover the cost of UI benefits in the recent deep recession. Many states entered the 2008-2009 recession with too little money in their UI trust funds to pay UI benefits during a prolonged and severe recession. About 30 states have been forced to borrow money from the U.S. Treasury to finance part of the cost of their UI benefits. These states have borrowed about $42 billion from the federal government. The stimulus package passed by Congress in February 2009 allowed states to borrow interest-free from the federal Treasury during 2009 and 2010. However, states with large loans from the federal Treasury must eventually start paying interest to the U.S. Treasury on their loan balances. In addition, employers in states which have outstanding loans from the Treasury for more than a couple of years must pay a higher UI “penalty tax” to the federal government until the state’s loan is fully repaid.

News reports available on February 8th suggest the Obama Administration will propose to defer temporarily interest payments that states owe on their loans and suspend for two years the imposition of higher federal “penalty taxes” in states that have long-standing UI loans from the federal government. At the same time, it will ask Congress to increase the taxable “wage base” for the federal UI tax from $7,000 to $15,000 starting in 2014. Employers must currently pay the federal UI tax on the first $7,000 in annual wages that they pay to a worker. If the Administration’s plan is enacted, the first $15,000 per year of a worker’s wage will be subject to the federal UI tax, more than twice the level of earnings subject to the tax today.

This proposal is widely interpreted to be an increase in the UI tax. It is not. It is simply an increase in the amount of a worker’s wage that is subject to the tax. The Obama Administration apparently intends to ask Congress to reduce the federal UI tax rate by enough so that the total amount of federal revenue raised by the tax remains roughly unchanged. Employers will be paying the UI tax on a larger portion of workers’ wages, but they will pay a lower tax rate on the wages that are taxed.

Many states will be forced to increase their state UI taxable wage base to $15,000 when the federal government increases the federal tax base. Thirty-two states and the District of Columbia currently have a wage base that is less than $15,000. If a state increases its tax base and does not reduce the UI tax rate applied to taxable wages, the revenue raised by the UI tax will increase. However, state legislatures may choose to reduce the statutory tax rate that is applied to taxable wages. Whether the revamped tax raises more revenue than the current tax depends on the tax rate that legislatures choose.

Most economists, including me, think it is preferable to impose a low tax rate on a large tax base rather than to impose a high tax rate on a small tax base. A high tax rate is likely to cause greater labor market distortions. In a state where only the first $7,000 of wages is taxed, employers essentially pay the same total tax for every employee on their payrolls. In addition to being a very regressive tax, this is also a very distortionary way to raise revenues. When an employer wants to expand production and increase the work hours of its employees, the present UI tax imposes a much greater tax increase if the employer adds to the number of its employees compared with adding to the work week of its current employees. In a labor market with 9% unemployment this is an especially foolish distortion. We do not want to raise revenue for the UI system in a way that discourages employers from adding to their payrolls and encourages them to lengthen the workweek of employees who are already on their payrolls.

The Administration’s plan to overhaul the UI tax is sensible. Given the severity of the recession and the high current rate of unemployment, it makes sense to delay imposing higher payroll taxes on employers in the states with big outstanding loans to the federal government. Many of these states experienced more severe downturns than the nation as a whole. The Administration’s proposal to increase the UI taxable wage base is also a small step in the right direction. The plan would be greatly improved, however, if the tax base were increased much more and then adjusted every year in line with the growth in average wages. I recently proposed that the federal UI wage base be raised to one-half of the taxable wage base in Social Security. The current Social Security wage base is $106,800, or more than 15 times the federal wage base for unemployment insurance. Unlike the federal UI tax base, the Social Security wage base is increased every year in which the average U.S. wage increases.

Notice that increasing the percentage of wages that is included in the tax base does not necessarily increase the amount of revenue raised by the tax. Whether tax revenues rise or fall depends on the tax rate that legislatures choose when they increase their taxable wage base. If state legislatures reduce the UI tax rate at the same time they increase their wage base, total revenues raised by the tax may remain unchanged or decline. For most states – and all the states with big loans from the Treasury – it would be a terrible idea to cut the tax rate by so much that UI tax revenues fall. But if states must raise a target amount of revenue with their UI tax, it makes much more sense to apply a low tax rate to a large tax base than it does to raise the revenue with a sky-high tax rate applied to a very small tax base.