Unemployment Insurance Administrative Financing Reform: The Real Story
June 2004
By the National Employment Law Project

The Bush Administration, for the third consecutive year, is promoting so-called “reform” of the federal unemployment insurance (UI) administrative financing system. A paper released by the U.S. Department of Labor, “UI Administration and Tax Reform Discussion Draft,” advances a concept of UI reform focused on federal payroll tax reductions conditioned upon states assuming responsibility for funding their state UI agencies. Interested parties in the UI field are now reacting to the discussion draft. As formulated by elements within the Bush Administration, UI administrative reform contains serious flaws.

• The discussion proposal is more properly framed as a federal payroll tax cut, pure and simple. It does not provide additional resources for state UI administration. There is no federal assurance that states can or will levy replacement taxes to fund UI agencies.
• Reducing the Federal Unemployment Tax Act rate from 0.8 percent to 0.6 percent in all states, and to 0.2 percent in states assuming responsibility for state UI agency funding will undercut the federal role in UI administration and effectively dismantle the federal-state UI program. The resulting abrogation of federal responsibility for assisting jobless workers represents a significant retreat from promises made over 65 years ago with passage of the Social Security Act.
• State choice adds nothing substantive to this year’s UI administrative reform discussions. Giving states an option to participate in UI administrative reform is illusory, since employer groups will insist that governors and legislatures provide them with any available federal tax reductions, and states will face intense “business climate” competitive pressures to do so.
• During future economic downturns, electing state agencies will have to fight for increases in administrative funding to accommodate higher UI claims volumes. Given diminishing state resources and competing demands from other state programs in economic hard times, getting these added funds will prove difficult or impossible in most states.
• UI administrative financing reform as currently framed poses significant risks that UI benefit cuts or eligibility restrictions could be used to fund future state agency operations, especially during recessions.

This briefing paper overviews UI administration and tax reform as formulated in the discussion proposal, critiques the arguments offered in its support, and explains the shortcomings of the proposal. Based upon our analysis, we conclude that the discussion proposal fails to address the real problems concerning UI administrative funding while representing a real threat to the continued vitality of our federal-state UI program.

Administrative Financing “Reform” Overview

With the passage of the Social Security Act in 1935, the federal government abandoned its longstanding position that assisting jobless workers was a state and local responsibility. Instead, the federal government recognized that unemployment was a national economic issue and that addressing this problem was beyond the capability of state and municipal governments. Today, this federal role ensuring the existence of an unemployment insurance safety net to assist jobless workers is threatened.

Since its inception, the United States has operated its unemployment insurance (UI) program as a federal-state program. The federal government offers a “carrot” for states operating a UI program meeting basic federal requirements—a state’s employers receive a substantial credit against the Federal Unemployment Tax Act (FUTA) payroll tax. This credit reduces the FUTA tax on wages for employers in conforming states, avoiding the “stick” of having the full 6.2 percent federal tax collected on employers in non-conforming states. Since all states qualify for the credit, the current effective FUTA tax is 0.8 percent of the first $7000 of each employee’s wages, or no more than $56 per employee annually.

Administration of state unemployment insurance agencies is paid for by the federal government with funds from the Federal Unemployment Tax Act (known as FUTA). In FY 2004, an estimated $2.76 billion flowed to states for administration of their UI programs. State administrative grants are distributed by the U.S. Department of Labor through a formula based upon state workloads for processing UI claims and collecting taxes. Through the federal budget process, Congress sets the total amount of UI administrative grants, but provides for increased administrative costs during times when economic conditions produce a higher volume of claims. In the FY 2005 budget for example, whenever average weekly insured unemployment (the number of people receiving a check or waiting for benefits) exceeds 3.32 million per week, an additional $28.6 million is released to states for every 100,000 additional people claiming unemployment benefits. Administrative costs for UI were 5.4 percent of benefit costs in FY 2003.

The Bush Administration recently renewed discussions of so-called “reform” of state UI agency financing by issuing a discussion draft in March 2004. This year’s proposal calls for a 25 percent cut in the FUTA rate in all states beginning in 2005 (or the calendar year following enactment). In addition, states would have an option to assume complete responsibility for state agency financing over a period of three years, with additional FUTA tax reductions for employers in those states. Overall, a total FUTA rate reduction of 75 percent (to 0.2 percent) is offered in these “electing” states starting with the third year after election. In other words, the current 0.8 percent FUTA tax would be 0.6 percent in non-electing states and 0.2 percent in electing state by FY 2009 if the discussion proposal were adopted.

To sweeten the pot and further encourage states to participate in its scheme, the Administration promises an additional $4 billion in future Reed Act distributions for electing states in FY 2005. The discussion proposal also provides elected states with 75 percent of their prior federal UI administrative grant in the first year of transition to state responsibility and 50 percent in the second year (FY 2007 and 2008). As an added incentive, the proposal provides electing state agencies with “hold harmless” administrative funding at a guaranteed percentage of current federal funding in the years following the assumption of state responsibility for UI agency funding (beginning FY 2009). However, the continuation of this lifeline for state agencies is subject to change by a future Congress in a context of reduced FUTA revenues.

The heart of the discussion proposal’s“reform” program is tax reduction. According to the Administration’s discussion draft, administrative financing reform is intended to “promote job creation and strengthen the economy by lowering federal payroll taxes.” Providing state agencies with more administrative funding or more reliable funding is NOT a stated goal. Providing improved services to jobless workers is NOT a stated goal. The ONLY stated goal is federal payroll tax reductions.

Since the 1930s, the federal government has funded UI administration by state agencies (as well as federal UI oversight activities) with appropriations from FUTA revenues. Critically, federal funds automatically increase with higher UI claims during recessions under current law. Since at least the 1940s, states have chafed at the amounts appropriated by Congress for UI administration. Continued state concern about federal administrative funding levels explains why some interested parties support reform, even though adequate funds are not guaranteed.

Unfortunately, the real problems with administrative financing–the overall amount of federal dollars and their distribution among the states–are not addressed in the Administration’s discussion proposal. While purporting to address state concerns, the Bush Administration's proposal reduces reliability of funding for state UI administration and leaves individual states largely to their own devices for agency funding during future economic downturns.

One difference in this year’s version of UI administrative reform is that states have an option on accepting responsibility for state agency funding, rather than requiring all states to do so. The presence of this state option does not represent a significant improvement in UI administrative reform because state choices offered under the proposal are illusory. Since states compete vigorously with each other with respect to “business climate,” governors and legislators will face overwhelming pressures to offer employers any available FUTA tax reductions. The idea that states can opt out while a decentralized, low-tax administration rises around them is an illusion. While prior versions of UI administrative reform involved dismantling the federal-state UI program directly, this year’s version has the same result but adds the illusion of state choice. The inclusion of state choice does not alter the substance of the proposal–tax cuts combined with greater state responsibility for funding UI agencies.

Supporters of maintaining a federal role in the nation’s UI programs need to oppose this year’s version of administrative reform just as firmly as with past versions. With preservation of the key elements of our federal-state UI program at stake in these ongoing discussions, no state should assume that it will escape the interstate competitive forces that the proposal’s adoption will unleash.

An Unnecessary FUTA Tax Cut

Since the Bush Administration’s UI administrative reform proposal is essentially about lowering FUTA taxes, there is an implicit argument that FUTA taxes need reduction. The Bush Administration discussion proposal reduces the current 0.8 percent effective FUTA tax rate ($56 per employee) to 0.6 percent in all states ($42), and to 0.2 percent (or $14 per employee) by FY 2009 in electing states. In return for this relatively minor federal payroll tax cut of $42, the nation will suffer a significant reduction in the reliability of administrative funding for state UI programs and risk reduced services and benefits to jobless workers.

In reality, there is no reason to believe that today's FUTA taxes are too high. First, today's $7000 FUTA taxable wage base covers an increasingly low proportion of total wages and the 0.8 percent net effective FUTA tax rate amounts to total taxes of only $56 a year, or 3 cents per hour for full-time workers.

Second, the current $7000 federal taxable wage base was set in 1983 and has not been raised since that time. While employer groups have long complained about frequent extensions of the 0.2 percent "FUTA surcharge," initially imposed by Congress in 1977 (and currently extended until FY 2007), when inflation in wages is taken into consideration, FUTA payroll taxes under the current 0.8 percent net tax rate are at their lowest levels over the entire history of the UI program. In other words, FUTA taxes are not excessive and FUTA tax reduction is not a compelling rationale for UI administrative reform.

Even if tax reductions are appealing, UI administrative reform is not a straightforward federal payroll tax reduction. There is a distinction between cutting federal taxes, and cutting federal support for existing state agencies without any assurance of sufficient replacement revenues at the state level. The administrative reform discussion proposal is not simply another federal tax cut, but rather a shifting of financial burdens from the federal government to the states in return for a federal tax cut. Because of this shift, any federal tax cuts under the current proposal must inevitably lead to state UI administrative tax increases, cuts in funding for state UI agencies and services to jobless workers, or outright UI benefit reductions (or some combination of these). There are no other realistic means to address the funding dilemma that states will face if UI administrative reform as formulated by the Bush Administration is adopted.

While additional Reed Act distributions and "hold harmless" funding may cushion some harmful financial impacts on electing states in the initial years, ultimately the day of reckoning for state UI agencies and programs will come. Indeed, the fact that the Bush Administration retreated from earlier, more far-reaching UI administrative financing reform proposals in light of current state budgetary woes is an admission that states are unable to assume the funding of state UI agencies in the current economic downturn. There is no reason to think that the next recession is going to be different in this respect. In short, overall state UI agency funding from all sources is very likely to fall if UI administrative reform as currently conceived is adopted.

Left Out of the Equation: Jobless Workers

The U.S. needs a world-class employment security system. To have a better employment security system, state UI agencies need adequate resources. Jobless workers need state agencies that provide prompt payment of benefits and effective job search assistance. The Bush Administration’s UI administrative funding proposal fails to address the need of jobless workers for adequately funded state UI agencies.

The original reason the federal government created the UI system using a “carrot and stick” approach was to counterbalance interstate pressures keeping individual states from adopting UI programs. Each state feared that competing states might not move forward with UI, gaining a “business climate” advantage over neighboring states with UI programs. These competitive pressures still exist and pervade state deliberations on their UI programs. The current reform proposal irresponsibly adds state agency funding into that interstate competition without ensuring that adequate replacement funding will be provided by the states. This approach abrogates the federal government’s role in ensuring income replacement for jobless workers for the sake of minimal federal payroll tax reductions. In our view, this is not a tradeoff worth making.

The performance of state UI programs over the years, especially in the South and Southwest, demonstrates that paying adequate benefits to jobless workers or ensuring that eligibility rules are fairly administered has been overridden by the imperative to keep state UI taxes low. Shifting UI agency funding to the states leaves the provision of critical benefits and services for jobless workers subject to these same political pressures. These budgetary pressures will worsen during economic downturns, and the resulting risk of program restrictions and poorly funded agencies is significant. Jobless workers will be hurt as a result. For this reason, UI administrative reform as currently conceived represents a significant retreat from the federal government’s overall responsibility for ensuring that a UI safety net exists in this country.

Avoiding Real UI Administrative Reform

One notable feature of UI administrative reform as presently conceived is its failure to address the real issues that have dogged the administration of the federal-state UI program. Two central questions have troubled the program’s administration over the decades. First, does Congress appropriate sufficient funding for state UI agencies? Second, does the U.S. Department of Labor allocate those appropriations among the states fairly? While these questions have proven difficult to answer to the satisfaction of all interested parties, the 2004 discussion proposal stands out by making no attempt to answer either of these longstanding questions. Instead of providing adequate federal support for state agencies that perform vital functions in our nation’s UI programs, the “reform” offered is openly designed to reduce federal payroll taxes and start dismantling the federal-state UI structure. Clearly, this "reform" proposal is not an answer to the real issues involving administrative financing of our unemployment insurance system.

Conclusion

The Bush Administration's 2004 discussion proposal for UI administrative financing reform is essentially a tax cut, resulting in less UI administrative funding for state UI agencies over the long term. The proposal doesn’t address insufficient levels of UI administrative financing that have long aggravated federal-state relations in unemployment insurance. Instead, using temporary "hold harmless" promises and one-time Reed Act distributions, it invites states to assume responsibility for state UI agency funding without ensuring that adequate alternatives exist. In the long-term, the proposal represents abandonment of federal responsibility for UI administrative financing and the welfare of jobless workers.

To contact NELP on this issue: Call Maurice Emsellem at (510) 663-5700 or email to emsellem@nelp.org or call Rick McHugh at (734) 426-6773 or email at rmchugh@nelp.org.

For further information on UI administrative financing:

Advisory Council on Unemployment Compensation, Defining Federal and State Roles in Unemployment Insurance (Washington, D.C., 1996), pp. 65-88, available at http://workforcesecurity.doleta.gov/dmstree/index.html.

Thomas E. West, et al., "Federal-State Relations," in Christopher J. O'Leary and Stephen A. Wandner, Ed., Unemployment Insurance in the United States: Analysis of Policy Issues (Upjohn Institute, 1997), pp. 574-583.

National Employment Law Project, Unemployment Insurance and the Bush Administration Budget: A "New Balance," or New Marketing for Bad Ideas? (March 2002), www.nelp.org.

National Employment Law Project, Questions and Answers About FUTA Taxes (April 2001), www.nelp.org.