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Pedro Amaral |

Senior Research Economist

Pedro Amaral

Pedro Amaral is a senior research economist in the Research Department of the Federal Reserve Bank of Cleveland. His main areas of research are macroeconomics and labor economics, and he is particularly interested in the effects of financial intermediation frictions as well as episodes of the Great Depression in countries where it occurred.

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Jessica Ice |

Research Analyst

Jessica Ice

Jessica Ice is a research analyst in the Research Department of the Federal Reserve Bank of Cleveland. Her primary interests include international economics, foreign exchange policy, economics of education and labor markets, and economic history.

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Brad Kaplita |

Intern

Brad Kaplita is an intern in the Research Department of the Federal Reserve Bank of Cleveland. He is pursuing a bachelor’s degree in economics at Rensselaer Polytechnic Institute. His work focuses on labor economics and financial markets.

08.12.14

Economic Trends

State Unemployment Insurance Policy Responses during the Great Recession

Pedro Amaral, Jessica Ice, and Brad Kaplita

During the Great Recession, state unemployment insurance systems faced unequal burdens depending on how well their accounts within the federal Unemployment Trust Fund (UTF) were funded and how severely they were hit by the recession. This article describes the different ways that states responded to the effects of the recession on their unemployment insurance systems because of these factors.

Financing Unemployment Insurance

The US unemployment insurance (UI) system is jointly funded by federal and state payroll taxes. The federal share is financed by a federal tax, charged to employers, of 6.0 percent on the first $7,000 of wages of each employee. (However, the effective tax rate is often 0.6 percent because of a 5.4 percent rebate that most employers get for paying on time). Revenues from the federal tax are used to cover state and federal administrative costs, for loans to states with insolvent UTF accounts, and for the federal share of unemployment benefits. The states’ share of UI claims is financed through a state tax, which is also levied on employers’ payrolls, but both the statutory rate and the taxable wage base (the amount of an individual’s income on which a tax is levied) varies from state to state.

When states have state tax revenues left over after paying their UI claims, they can supplement their UTF accounts. If they are unable to raise enough revenue to pay their UI claims, they can dip into their UTF accounts and obtain loans from the federal government. However, if a state is unable to repay its loans and its UTF account becomes insolvent for two consecutive Januaries, it will suffer a federal tax “credit reduction.”1 This means that the federal tax rebate that employers receive for paying their taxes on time will be reduced (usually by 0.3 percent per year, cumulatively, until the state is able to repay its loan). These federal tax credit reductions place a higher tax burden on employers, who may react by reducing payrolls, in turn decreasing the tax base for state tax revenues and placing more stress on the state’s unemployment agencies’ finances.

Insolvency during the Great Recession

In the aftermath of the Great Recession, states were faced with higher-than-normal unemployment compensation costs. During this period, the federal government was funding the large majority of unemployment compensation payouts in the form of the extended benefits programs, which offered a maximum of 73 weeks of benefits. However, federal benefits could not be paid out until an individual had exhausted the fully-state-funded unemployment insurance benefits, usually lasting 26 weeks. As claims increased with the onset of the recession in 2008-2009, federal tax credit reductions began posing a problem for a large number of states in 2011, as by that time they had had insolvent accounts for two years.

To look at how states in different fiscal situations behaved, we start by dividing them into three distinct groups: states that were never insolvent, states that were insolvent but managed to pay back their federal loans and did not incur the federal tax credit reduction, and states that became insolvent and ended up incurring a federal tax credit reduction.

States by Solvency Status

Federal tax credit reductions Insolvent without tax credit reductions Never insolvent
Arizona Alabama Alaska
Arkansas Colorado District of Columbia
California Hawaii Iowa
Connecticut Idaho Louisiana
Delaware Kansas Maine
Florida Massachusetts Mississippi
Georgia Maryland Montana
Illinois New Hampshire North Dakota
Indiana South Dakota Nebraska
Kentucky Tennessee New Mexico
Michigan Texas Oklahoma
Minnesota   Oregon
Missouri   Utah
Nevada   Washington
New Jersey   West Virginia
New York   Wyoming
North Carolina    
Ohio    
Pennsylvania    
Rhode Island    
South Carolina    
Vermont    
Virginia    
Wisconsin    

Sources: Department of Labor; Bivens, Smith, and Wilson (2014).

Unemployment Insurance Policy Responses

Unemployment rates were substantially higher in states that suffered federal tax credit reductions, while they were very similar in solvent states and states that were insolvent but managed to escape the federal tax credit reduction. Holding all things equal, states with higher unemployment rates need to spend more on unemployment claims and therefore will suffer more fiscal pressure. At the same time there may also be a feedback mechanism at work, creating a potentially vicious cycle: federal tax credit reductions increase the employers’ effective tax rates, which may lead to less hiring and higher unemployment.

Although on average states that did not receive the federal tax credit reduction faced lower unemployment rates, some states faced insolvency while others did not. A striking difference between the solvent and insolvent groups is the size of their statutory taxable wage base (the dollar amount of wages that taxes are levied on in each state). The statutory taxable wage base for solvent states was almost double that of insolvent states (regardless of whether they received a federal tax credit reduction or not). Moreover, since employment levels also tended to be lower for insolvent states, the total taxable wage base (the statutory wage base times the number of employed people) was also lower there. Thus, the data indicate that solvency depends not only on a state’s level of unemployment and the volume of claims it must pay, but also on how prudently it uses its fiscal instruments. In fact, one could make a strong argument that states with broad tax bases are precisely those that did not end up in insolvency.

The insolvent states eventually increased their statutory taxable wage base the most as a response to their fiscal woes. This policy response is unsurprising for two reasons: first, insolvent states began with a much lower taxable wage base and had much more room to grow it, and second, solvent states probably did not see any need to make increases, given their sounder fiscal situation.

States that went through insolvency also increased their maximum state payroll tax rate by more than both solvent states and states with federal credit reductions. Increasing the state tax perhaps contributed to the ability of some states to escape federal credit reductions by allowing them to repay federal loans while others did not.

While the fiscal consolidation effort for states that became insolvent but escaped federal tax credit reductions was done largely by increasing revenues, states that suffered federal tax credit reductions attempted to balance their trust fund budgets through reductions in spending. States with federal tax credit reductions kept the maximum dollar amount of weekly UI benefits the unemployed could receive constant and reduced the maximum number of weeks that an individual could receive state UI benefits. Note that this strategy does not necessarily mean they were able to cut overall spending, as unemployment rates, and therefore claims, were higher in these states.

To be sure, the way states have managed the funding of their UI programs in the past is as important a determinant of the current fiscal situation of those programs as the unemployment burden the state faces. Moreover, unemployment at the state level is also partly determined by past and current fiscal policies, so we are not claiming any causality, but merely pointing to some important, and suggestive, correlations. Based on this evidence, states that escaped a federal penalty were faced with a less severe unemployment burden and they also undertook some policy measures to increase their revenues by increasing their taxable wage base and state maximum tax. States that suffered federal tax credit reductions also experienced more adverse labor market outcomes and took additional measures to reduce deficits through attempts to reduce their spending on unemployment insurance programs.

Footnote

  1. These credit reductions are officially titled Federal Unemployment Tax Act or “FUTA” credit reductions.[Back]

The authors thank Lockhart Taylor at the North Carolina Department of Commerce for his contributions to this article.