Federal Meddling With State Unemployment Systems

William Weissman
August 5, 2009 — 1,978 views  
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The national unemployment rate recently hit 9.5 percent, and an estimated 7.2 million jobs have been lost since the recession began in December 2007. Several states' unemployment funds are now insolvent and borrowing money from the federal government. President Obama recently acknowledged that unemployment is likely to get worse, hitting double digits, before it gets better.

Unemployment taxes are unique. While there are separate state and federal unemployment taxes, they are linked by giving employers a credit against federal taxes for paying their state taxes on time. Also, while federal taxes are paid, there is no separate federal unemployment system; rather, it is the states that have to administer the programs that provide benefits to unemployed workers. And while the states are free to run their unemployment systems, they must comply with federal mandates that result in the states' systems being similar but not identical.

As part of the Obama administration's stimulus plan, the federal government offered additional funds for three years to assist the states in running their unemployment systems.[1]  Of course, like most things coming from the federal government today, those come with a lot of strings attached. For example, to get one-third of the funds, the states must modernize how benefits are calculated by including in the base period the wages earned in the most recent quarter.

Traditionally, workers were entitled to unemployment benefits only if they had earned a specific amount in wages during the base period, which was four quarters that started with the first full quarter before the last quarter. In effect, that meant a look-back period of as long as 18 months before the date when the person was claiming unemployment. The historic reason for that base period was simple: When the unemployment system was started in the 1930s, records were kept by hand on paper, and the states needed the extra time to get the records and sort through them to determine eligibility. Today, however, records are computerized, and the historical need for the extra time has disappeared.

It's disingenuous to suggest that the new requirement is intended to modernize the system when in reality it is intended to expand the rolls.

The real reason for the push to use the most current wages is that that is expected to increase by tens of thousands the number of persons qualifying for unemployment, thus providing a social safety net to far more persons. Although there is something to be said for modernizing the law to account for changing technology, those changes should be made only if they make the system operate more efficiently. Attempts to make changes solely to expand the rolls, however, should take into account far more than just the historical reason for updating the base period.

If the federal government wants to expand the unemployment rolls, it could mandate that the states allow anyone earning as little as $1 to qualify for benefits, or some other ridiculous standard that almost anyone could meet. It's disingenuous to suggest that the new requirement is intended to modernize the system when in reality it is intended to expand the rolls.

To receive the other two-thirds of the funding, states must accept at least two of the following four conditions:

  • Part-time workers must be entitled to benefits despite seeking only part-time work.
  • A worker must be entitled to benefits when he or she separates from employment for a "compelling family reason," which includes a family illness, domestic violence, or a spouse's relocation.
  • A worker who has exhausted all rights to employment benefits but is enrolled and making reasonable progress in a state-approved training program, as authorized by the Workforce Investment Act of 1998, cannot be denied additional unemployment benefits, provided that no benefits need to be granted to the extent the worker is also receiving similar allowances or stipends from other programs.
  • Workers receiving benefits who have dependents must receive a dependent allowance equal to no less than $15 per dependent, subject to aggregate limits.

Essentially, all those extra requirements are likely to either expand the rolls or saddle the states with additional long-term costs that will continue long after the federal stimulus money has run out.  For example, generally a person going to school was unavailable for work and thus ineligible for benefits, but under the stimulus plan he could be eligible if he is looking only for part-time work and is enrolled in a state-authorized training program. In other words, people who are going to school may now be able to get unemployment because they are doing something they were going to do anyway.

Officials in several states, not being as naïve as Congress might have thought, have rightly rejected the federal stimulus money. For example, in a February 20 press release, Louisiana Gov. Bobby Jindal (R) explained why he was declining the less than generous offer:

Our state is facing a serious budget situation and it would be irresponsible to enter into an expansion of benefits right now that would ultimately increase taxes on the very businesses we are working to support during these tough economic times. The federal money in this bill will run out in less than three years for this benefit and our businesses would then be stuck paying the bill. We must be careful and thoughtful as we examine all the strings attached to the funding in this package. We cannot grow government in an unsustainable way. 

I strongly suggest that other states also look closely at this provision in the bill so they can also avoid ultimately passing on a significant tax to businesses that will be left paying for this expansion of benefits when the federal money dries up.

Increasing taxes on our Louisiana businesses is certainly not a way to stimulate our economy.  It would be the exact wrong thing we could do to encourage further growth and job creation.[2]

The governor's press release went on to detail the financial implications of accepting the federal money, noting that Louisiana would receive about $32.8 million in benefits over three years but would then be stuck with $12 million in additional costs per year thereafter because of the permanent changes in Louisiana law. Further, those figures are based on the assumption that the economy does not get worse, in which case even more in benefits would be paid than predicted.[3]

Several other governors, including Alabama Gov. Bob Riley (R) and Texas Gov. Rick Perry (R), issued similar statements, saying that the structural changes Congress is demanding would have significant long-term effects on the states that, on balance, were not worth the short-term infusion of cash.

Other states, however, have taken a different view of the burdens increased taxation will have on their local businesses. For example, Tennessee just enacted a midyear unemployment tax increase tied 'to the solvency of the state's unemployment insurance fund that raises both the new employer rate from 2.7 percent to 3.3 percent, and the wage base limit from $7,000 to $9,000.[4]  To receive the federal stimulus funds, Tennessee changed its definition of a base period to include the most recent wages and adopted the $15-per-dependent and part-time work requirements.[5]

Many businesses have already made what had been the full unemployment contributions for employees who were employed on January 1, because they had already earned $7,000 this year to date, the maximum under Tennessee's law before the recent amendments. Thus, companies that have paid those taxes, but did not budget for the additional taxes, will have to find that money somewhere. That is likely to be more difficult for small, struggling businesses.

Nonetheless, the bill's supporters appeared to believe that it was the lesser of two evils. They said that the state's unemployment insurance fund would likely go insolvent, causing it to borrow from the federal government and repay those amounts with interest.[6] They also seemed to think that in a few years (after the federal stimulus money was used up and the unemployment fund became more solvent), they could just change Tennessee law back to how it was, thus making only temporary changes to obtain the federal funds.[7]

The push to significantly expand the rolls is part of the desire of some government officials to provide a minimum floor of benefits for all workers. But that creates additional burdens on businesses, which at some level becomes counterproductive. In California, for example, the unemployment insurance fund went insolvent on January 26,2009, when it started to borrow funds from the federal government. The projected shortfall at the end of 2010 is expected to be $17.6 billion.[8] Last November Gov. Arnold Schwarzenegger (R) proposed increasing the wage base limit from $7,000 to $10,500 and raising the maximum rate from 6.2 percent to 8.1 percent. That in effect amounts to a 95 percent tax increase. Other pending legislation proposes raising taxes even more.[9]

Some business owners have said that to pay the tax increase, they likely will have to layoff employees, adding to the vicious cycle of unemployment. A recent article in the Los Angeles Business Journal quoted small-business owner Steve Diels, a Redondo Beach City Council member who employs 38 people at Aamcom Inc.:

Right now, my profit margin has slipped and I'm doing everything I can to avoid laying anyone off. But if they increase the unemployment tax, employers like me will have to lay people off and that will only make things worse with the unemployment fund.[10]

With California facing an anticipated unemployment rate of 12 percent, the last thing it needs is more unemployment. Given California's other financial problems, however, it is not clear whether unemployment taxes will be tackled any time soon.

While California received some federal stimulus money, it is unlikely that it will be enough to stop the bleeding.

There is no doubt that the nation as a whole is suffering from significant unemployment, and the costs associated with it are high. However, the federal government's approach of offering short- term aid in exchange for significant long-term expenses simply does not add up for the states, even in a state like California. The government should consider other proposals to solve unemployment that do not merely make it easier to obtain benefits while tacking on massive long-term tax increases to businesses already struggling to survive.

The federal government's approach of offering short-term aid in exchange for significant long-term expenses simply does not add up for the states.

One approach would be to allow the states to abandon the unemployment insurance system altogether and let the federal government administer it through a federal agency such as the Social Security Administration. The federal government could impose whatever requirements it chooses, and the states would not have to incur the costs associated with administering the system. The reduction in the administrative redundancies from state to state likely would save millions that could be used to pay benefits rather than bureaucrats, and using a single, consistent tax nationwide would eliminate tax arbitrage. But because that is not likely to happen, other changes will be necessary.

Of course, the best way to reduce unemployment costs is not to have unemployment. The only way not to have unemployment is to have an economy that is creating jobs. But jobs are not readily created when businesses are getting crushed by excessive government regulation and taxation. Enterprising individuals who might want to start businesses are often discouraged because of the cost and red tape. Further, sole proprietorships are an anathema to the states because they do not pay unemployment  taxes.  Thus, even if workers want to strike out on their own, the government, rather than supporting that idea, seems to discourage it. Governments should recognize that a self-employed individual who does not pay unemployment taxes has a greater effect on reducing overall unemployment costs than an unemployed individual who collects far more in benefits than her former employer paid in taxes. That does not seem to be a lesson the federal government or the states have learned.

Taxing Times - A Practitioner's Perspective is a column by William Hays Weissman.

Previously Published in State Tax Notes on July 27, 2009.

[1] H.R. 1, section 2003.

[2] Gov. Bobby Jindal press release, "Governor Jindal Declines Stimulus Provision That Would Result in an Unemployment Tax Increase on Businesses," Feb . 20, 2009.

[3] Id.

[4] HB 2324, signed by the governor on June 25, 2009.

[5] Id.

[6] Tom Humphrey, "House Approves Tax Increase to Support Jobless Benefits," Knoxneuis.com, June 1, 2009.

[7] Id.

[8] California Employment Development Department, "May 2009 Unemployment Insurance (UI) Fund Forecast," pp. 1-3.

[9] See SB 222, seeking to raise the wage base limit to $21,000 , and thus tripling the tax, and AB 1298, raising the wage base limit to $16,600 and the top rate from 6.2 percent to 7.5 percent.

[10] Howard Fine, "Tax May Feed Unemployment: Business Owners Fear Insurance Spike," Los Angeles Business Journal, Mar. 30, 2009.

William Weissman


Mr. Weissman is a shareholder in Littler Mendelson's Employment Taxes Practice Group. He advises and represents employers in a broad range of employment tax matters, including employment tax audits, protests and appeals before state taxing agencies and the IRS as well as litigation in civil court, drafting employment and independent contractor agreements, and counseling on the tax implications of various employer provided benefits. He is currently the Vice Chair and Chair Elect of the Employment Taxes Committee of the American Bar Association's Tax Section.