Unemployment Insurance: States' Tax Financing Systems Allow Costs to Be Shared among Industries
Published: 2006-07-26T00:00:00

Fast Facts:

Highlights:
section_title: Why GAO Did This Study
paragraphs: In 2006, the Unemployment Insurance (UI) program is expected to collect over $37 billion in taxes from employers to pay $34 billion in benefits to unemployed workers. Under state UI programs, employers' tax contributions are experience-rated--that is, they reflect the extent to which they laid off workers who then collected benefits. To examine the equity of this system, we met with officials from five states, reviewed prior studies, and examined state data to determine (1) how states ensure that employers pay UI taxes based on their experience with unemployment, and the aspects of state unemployment insurance systems that limit experience rating; (2) the extent to which employers pay unemployment insurance taxes commensurate with unemployment benefits paid to their former employees; and how this varies by industry; and (3) steps states could take to increase the degree of experience rating. We provided a draft of this report to the Department of Labor (Labor) for its review. Overall, Labor agreed with our findings.
section_title: What GAO Found
paragraphs: All state Unemployment Insurance-financing systems are experience-rated, but several aspects of these systems limit the connection between an employer's tax contributions and the employer's experience with unemployment. For example, a state's maximum tax rate limits the size of an employer's tax payment, regardless of the costs an employer may have imposed on the system. Similarly, a minimum tax rate ensures that an employer's tax rate will not drop below a specified floor, no matter how much its experience rating improves. Other aspects of state systems allow the cost of some benefits to be charged to all employers rather than to a single employer. These shared costs include, for example, benefits paid to unemployed workers of a firm that has gone out of business. When the cost of benefits is shared in this way, it reduces experience rating and imposes additional costs on all employers. A series of studies that examine experience rating in state UI systems show that a number of industries used more in benefits than they paid in taxes to finance the system. Certain industries, such as construction and agriculture, forestry, and fisheries, as a whole, consistently received such subsidies, while other industries, such as finance, insurance, and real estate tended to pay subsidies. Newer firms that are not yet experience-rated, regardless of industry, also tend to pay subsidies. Our analysis of more recent data from three states found a similar pattern of subsidies. States could increase experience rating and reduce subsidies by adjusting aspects of the unemployment insurance tax structure, such as the maximum tax rate. However, each of these adjustments has trade-offs that would have to be considered by a state because the adjustments would raise costs for some employers or reduce costs for others. In addition, such adjustments would have to be evaluated based on the implications for other policy objectives established for a state's unemployment insurance program.

section_title: Letter
paragraphs: Unemployment compensation is a social insurance program designed to  partially replace the lost wages of individuals who become involuntarily  unemployed and to stabilize the economy in times of economic recession.  In partnership with the federal government, individual states administer  the Unemployment Insurance (UI) program and fund benefits through  payroll taxes levied on employers. In 2006, employers are projected to  make state unemployment tax contributions of over $37 billion, and an  estimated $34 billion will be paid in benefits to unemployed workers.
All state UI systems are experience-rated so that employers’ contribution  rates are risk-based, and nearly all vary according to how much or how  little their workers received unemployment benefits.  In principal, this  means that an employer who lays off many workers that claim  unemployment insurance benefits will pay more in taxes than an employer  that lays off fewer workers that claim benefits. However, very limited  federal guidance governs how states are to implement the experience- rating provision. Further, because unemployment programs serve as social  insurance programs, it is generally recognized that some high-layoff  employers may, over time, pay less in taxes than benefits paid to their  former workers, while other employers may pay more.
Wanting to know about the equity of state systems of unemployment  insurance financing, you asked that we explore how the taxes that pay for  the system are distributed among employers. Specifically, we addressed  the following questions:  1.  How have states ensured that individual employers pay unemployment  insurance taxes based on their experience with unemployment, and  what aspects of state unemployment insurance systems limit such  experience rating?  2.  To what extent do employers pay unemployment insurance taxes  commensurate with unemployment benefits paid to their former  employees, and how does this vary by industry?  3.  What steps could states take if they wished to ensure that the taxes  paid by individual firms more closely matched the benefits paid to the  former employees of each firm?
To answer the first and third questions, we reviewed pertinent literature  and interviewed Department of Labor (Labor) officials and officials of  national organizations representing the perspectives of business, labor,  and state unemployment insurance agencies, as well as nationally  recognized experts on unemployment insurance. We also conducted in- depth interviews with representatives of unemployment insurance  agencies in five states—California, Illinois, Michigan, Texas, and  Washington. We selected these states because they are relatively populous  and geographically dispersed, and because they take different approaches  to ensuring experience rating. We discussed each state’s approach to  financing unemployment insurance benefits, and the implications that  various aspects of these systems had for experience rating and the  existence of cross-subsidies. In addition, we reviewed pertinent  documents describing the unemployment insurance-financing systems in  each of these five states. To answer the second question, we identified and  reviewed 10 studies published between 1972 and 2000 that measured how  closely taxes paid by firms and industries matched the benefit costs they  imposed. We confirmed with the  Department of Labor and national  experts on unemployment insurance that these 10 studies constituted the  definitive work done to date on this subject. To supplement these studies,  we obtained data on tax and benefits payments by industry type from  three of the five selected states. We determined that the data were  sufficiently reliable for our purposes. See appendix I for more details on  scope and methodology.
We conducted our work between September 2005 and June 2006 in  accordance with generally accepted government auditing standards.
subsections: section_title: Background
paragraphs: The unemployment insurance program was established in 1935 to (1) give  workers temporary and partial insurance against income loss during  unemployment for which they are not at fault, and (2) to help stabilize the  nation’s economy in economic downturns by maintaining workers’  purchasing power. The program operates as a partnership between the  states and the federal government. Under this arrangement, Labor  provides broad policy guidance and program direction, while the states  design and implement specific program details. Within certain limits,  states have broad autonomy in carrying out their basic program  operations. They decide the requirements that unemployed workers must  meet for eligibility, the amount of benefits, and the length of time they will  pay benefits. They also decide on the tax rates employers must pay on  their payrolls. Further, states can and do make changes in these and other  aspects of their unemployment insurance system. As a result, state  eligibility requirements, benefit levels, payroll tax rates, and trust fund  balances vary, reflecting variations in program decisions and the economic  fortunes of each state.
Federal and state payroll taxes on employers finance the UI program. The  federal government uses the proceeds from its payroll tax to (1) pay for all  program administrative costs and one-half of extended benefit payments  and (2) maintain a loan account from which financially troubled states can  borrow funds to pay UI benefits. The gross federal tax rate is 6.2 percent  on the first $7,000 paid annually by employers on each employee. If a state  meets federal requirements, and has no delinquent federal loans, however,  its employers are eligible for up to a 5.4 percent credit, making the net  federal tax rate 0.8 percent. To receive the maximum federal tax credit,  states must, among other things, establish a taxable wage base for state UI  taxes at least equal to the federal wage base—currently $7,000.
Most of the funds used to pay UI benefits come from the states, which levy  a payroll tax on employers to finance regular UI benefits and one-half of  extended benefits.  States generally structure their UI taxes to include  several tax rate components or schedules. In accordance with federal law,  within a tax schedule, an employer’s tax rate will vary according to the  firm’s experience in laying off workers who subsequently receive UI  benefits, commonly called their experience rating. Those firms with many  unemployed workers receiving UI benefits will generally pay a higher UI  tax rate than firms with few workers receiving unemployment insurance.  These tax rate schedules also vary according to some measure of a state’s  trust fund balance, with the highest tax schedules generally applying when  state fund balances have fallen below a specified level. Each state  maintains its own trust fund with the U.S. Treasury that is used for  depositing program income and from which UI benefits are paid.
section_title: States’ Unemployment Insurance-Financing Systems Limit the Degree of Experience Rating
paragraphs: tax rates, and (2) the equitable allocation of costs of unemployment  benefits.  .  Although all state and territorial unemployment insurance programs base  an employer’s tax rates on its experience with unemployment, the design  of each state’s financing system also limits the degree of experience rating.  Nearly all state programs, for example, base tax rates on some measure of  benefits paid to a firm’s former workers. However, all states have a  maximum tax rate that limits the financial liability of an employer,  regardless of the amount of benefits paid to a firm’s former employees. As  a result, some employers will, over time, pay less than the full costs of  benefits attributed to them. Also, some benefits are paid but not charged  to an individual employer, partly because the employer is not at fault.  These and other design features allow an employer’s total tax payments to  vary from total attributed benefits, over time.
subsections: section_title: Nearly All States Base Experience-Rated Tax Rates on Benefits Paid to a Firm’s Former Workers
paragraphs: All state unemployment insurance programs adjust the tax rates of  individual firms on the basis of their experience with unemployment, and  50 of the 53 systems do so based on one of two basic systems—the  reserve ratio system or the benefit ratio system.
In these 50 states, when unemployment insurance benefits are paid to a  worker, the value of those benefits is “charged” to the worker’s former  employer or employers. Under both systems, benefits payments charged  to a firm over a defined period of time become a key basis for an  employer’s experience rating. However, the reserve ratio system and the  benefits ratio system also have important differences.
Under the reserve ratio system—used by 33 state and territorial  unemployment insurance programs—states set up an account for each  experience-rated employer. All taxes paid by an employer are credited to  this account, and benefits to a firm’s former employees are debited from  this account. Ordinarily, this balance—or “reserve”—is carried forward  from year to year. The balance of this account is positive if cumulative tax  payments are larger than cumulative benefits charged, and negative if  cumulative tax payments are smaller than cumulative benefits charged. In  each year, each employer’s experience rating—the reserve ratio—is  developed by dividing the firm’s reserve balance by a measure of the  wages paid by the firm—in most cases, an aggregate or average of 3 years’  taxable wages. Table 1 illustrates the calculation of an experience rating  using the reserve ratio method.
The benefit ratio approach, used by 17 of the 53 state and territorial UI  systems, does not consider employers’ tax contributions, but only benefits  charged over a defined period, usually 3 years. As with the reserve ratio  system, benefit charges are divided by a measure of the firm’s total wages,  such as payroll over 3 years. Table 1 illustrates the calculation of an  experience rating using the benefit ratio method.
Once a state has established an employer’s experience rating as measured  by the reserve ratio or the benefit ratio for a tax year, these experience  ratings are used to determine an employer’s tax rate. In general the basic  tax rate is determined through use of a tax rate schedule, and in some  states through use of a formula. The basic experience-rated tax rate can  also be adjusted in response to other considerations, such as the solvency  and financial health of the trust fund or to cover shared costs. As table 1  illustrates, employers with high reserve ratios pay relatively low tax rates,  and those with low reserve ratios, especially employers with negative  reserve ratios, pay relatively high taxes. Conversely, the higher a benefit  ratio, the higher an employer’s tax rate.
Each year, an employer’s tax payment is calculated by multiplying the tax  rate by the employer’s taxable wage base. Under federal law, the taxable  payroll must be at least the first $7,000 in wages paid to each employee,  but state taxable payrolls vary from this minimum up to $32,300.
In any given year, both the reserve ratio and the benefit ratio systems  allow for considerable differences between tax payments and benefit  charges. In theory, unemployment insurance programs rely on a forward- funded approach. Typically, the trust fund is replenished when tax  payments exceed benefit payments during times of low unemployment.  Conversely, trust funds are depleted during times of high unemployment  because benefit payments exceed tax revenue. By design, higher tax  payments lag behind increased benefit payments, in part so that employers  are not burdened with higher tax rates during times of economic difficulty.  Because the reserve ratio is based on the full history of an employer’s  benefit charges and tax payments, it will change less abruptly because of  an increase or decrease in benefit payment than the benefit ratio.  However, both are designed to partly recoup charged benefits and ensure  some degree of equity among employers over multiple years.
section_title: Several Aspects of State UI Systems Limit the Linkage between Tax Rates and Benefits Paid to a Firm’s Former Workers
paragraphs: Although the large majority of state UI systems have implemented  experience-rated systems that ensure a linkage between taxes paid and  benefits charged, several aspects of state UI systems limit this linkage. As  a result, state UI systems are only partly experience-rated, and a firm’s UI  tax payments can be substantially determined by factors other than  benefits charged.
subsections: section_title: Benefit Write-offs and the Time Value of Money
paragraphs: Although benefit ratio and reserve ratio systems establish, for each  employer, a basis for a tax rate linked to benefits charged, they both have  important limitations in this regard. First, benefit ratio and some reserve  ratio systems do not have perfect memories of benefits charged. Typically,  benefit ratio systems consider benefit payments over the previous 3 years.  For example, benefit payments, charged to a firm in years prior to the   3-year range, even if not fully recaptured in tax payments, are not  considered in calculation of taxes for future years. Similarly, while reserve  ratio systems generally are supposed to reflect the balance between all  benefits charged and all taxes paid since enactment of a state’s  unemployment insurance law, this does not always occur in practice. Six  of the 33 states that use the reserve ratio system have provisions for  effectively writing off benefit charges if the firm’s reserve balance or  reserve ratio sinks below a certain level. For example, the California  unemployment insurance program writes off benefit charges if an  employer has a negative balance that would otherwise exceed 21 percent  of average taxable payroll during the last 3 calendar years. When these  negative balances are forgiven, the benefit charges are effectively erased  from the record of an individual firm. In both the case of a reserve ratio or  a benefit ratio system, benefits that were once attributable to an individual  firm become the common burden of all employers.
A second major factor that limits the degree of experience rating is that  these systems do not take into account the time value of money. For  example, employers in a state using the reserve ratio approach may—by  consistently paying less in taxes than the amount of chargeable benefits  paid to former workers—carry a significant and growing negative balance  for many years. Because states maintain records in nominal dollars, such  negative balances understate the real cost that such employers have  imposed on the state’s unemployment insurance trust fund. Conversely,  employers that consistently maintain significant positive account balances  are not compensated for these balances—the nominal balance understates  the real contribution such employers have made to the state’s trust fund.  The same effect may occur in states using the benefit ratio system, but  because of the 3-year time horizon on the benefits that affect the tax rates,  there is less potential for this practice to have a large cumulative effect.
section_title: Maximum Tax Rates
paragraphs: While all states vary an employer’s tax rate on the basis of experience  rating, all states have also established maximum tax rates that limit an  employer’s tax liability. In accordance with federal guidelines, states must  have a maximum tax rate of at least 5.4 percent. However, as table 2  indicates, maximum tax rate policies differ markedly from state to state— ranging from 5.4 percent in 13 states to 15.4 percent in Massachusetts.
The maximum tax rate may cause a departure from experience rating in  certain circumstances for two reasons. First, as a result of maximum tax  rates, firms with very different experience ratings will be assessed the  same tax rate. For example, an employer that is just at the threshold of the  maximum tax rate will pay the same tax rate as an employer whose  experience rating indicates a much greater propensity to lay off workers.  Figure 1 illustrates this effect using an example from California. According  to one of the tax schedules used in that state, all employers with reserve  ratios of -0.11 or less pay at the maximum tax rate of 5.4 percent.  Consequently, an employer with a reserve ratio of -0.20 or worse will pay  the same tax rate as an employer with a reserve ratio of -0.11.
The second departure from experience rating occurs because the  maximum tax rate causes some firms to pay considerably less in taxes  than benefits charged. Because of the maximum tax rate, it is possible that  an employer will continue to pay less in taxes than benefits charged year  after year. For example, an Illinois firm with 100 employees at a maximum  tax rate of 9.0 percent and a taxable wage base of $10,500 per employee  will pay a total of $94,500 in taxes in a year. Assuming this employer laid  off 15 workers who each earned $673 per week, each worker would qualify  for unemployment insurance benefits of about $8,400, or a total of about  $126,000. In a single year, the employer’s workers would receive about  $31,500 more in benefits than taxes paid by the employer. If this pattern  continues for multiple years, the maximum tax rate would prevent the  employer’s tax contributions from increasing, and the difference between  benefits charged and taxes paid may become a permanent subsidy to the  employer.
In conjunction with the maximum tax rate, employers’ tax contributions  are also limited by the level of the taxable wage base set by the state.  Because an employer’s tax rate is multiplied by its taxable wage base to  determine its tax payments, an employer paying at a given tax rate will pay  less tax than an employer at the same tax rate with a higher taxable wage  base. While federal law requires a $7,000 minimum taxable wage base,  table 2 shows that taxable wage bases vary significantly from state to  state, ranging from the $7,000 minimum in nine states to $32,300 in Hawaii.
section_title: Minimum Tax Rates
paragraphs: Just as states set maximum tax rates, most states also set minimum tax  rates greater than zero. Minimum tax rates ensure that an employer’s tax  rate will not drop below a specified floor, no matter how much its  experience rating improves. Consequently, employers with significantly  different experience ratings may have the same tax rate. Figure 1  illustrates that employers with a reserve ratio greater than 0.20 would pay  at the minimum rate of 0.7 percent. As table 2 shows, minimum tax rates  even at the highest rate schedules vary widely among the states—from  zero in five states to 2.85 percent in Arizona.
section_title: Tax Rate Increments
paragraphs: The method states use to assign an employer a tax rate, and the range of  possible tax rates between the minimum and the maximum tax, also  affects the degree to which a state UI system is experience-rated. Some  states use tax schedules to assign employers whose benefit ratio or  reserve ratio falls within a particular range a particular tax rate. Such  schedules—if they have relatively few tax rates and broad intervals  between the rates—can limit experience rating because employers with  different experience ratings will pay at the same tax rate. Also, if the  difference between one tax rate and the next is substantial, employers  with nearly identical experience ratings may pay significantly different tax  rates. As Labor noted in 1983 guidance to states, within the limits of the  maximum and minimum rates, the smaller the intervals between the  variant rates, the greater the effect of individual employer experience on  the employer’s tax rate. Further, numerous differential rates make the  transition from one tax rate to another more equitable because two  employers with almost identical experience ratings could have different  tax rates if they are on either side of the border between two rates. More  tax rates will help ensure that the difference between one rate and the  next is smaller.
section_title: Some Costs Are Shared among All Employers, a Fact That Contributes to Differences between Benefits Charged and Taxes Paid
paragraphs: State unemployment insurance funds bear some costs that cannot be  recovered from the individual employer that might otherwise be  considered responsible for such benefit costs. Such costs become the  common burden of all employers, and for this reason can be referred to as  shared costs. Such shared costs fall into three general categories:   (1) benefits that are charged to a specific active employer but are not fully  recovered from that firm in tax revenue, (2) benefits paid to former  employees of firms that have gone out of business and cannot make  additional tax payments, and (3) benefit payments made to workers that  are not charged to a specific employer.
subsections: section_title: Charged Benefits That Are Not Covered by Responsible Employers’ Tax Payments.
paragraphs: Some aspects of state unemployment insurance programs prevent the tax  payments of some employers from matching charged benefits. For  example, if over multiple years, an employer’s benefits charges amount to  $50,000 but because of a maximum tax rate, the firm pays only $43,000 in  taxes, the state must raise revenue to cover the costs of this difference. As  a result, such costs become the common burden of all firms in the  unemployment insurance system.
This aspect of shared costs can be a substantial portion of total benefits  paid. Labor publishes one measure of such costs, referred to as ineffective  charges. In 2004, the most recent year for which data are available, such  ineffective charges ranged from 2.5 percent of total benefits paid in North  Dakota to 38.7 percent in Arizona. In other words, only 2.5 percent of total  benefits payments in North Dakota were charged to active employers who  did not pay taxes to cover these benefit costs. In Arizona, 38 percent of all  benefit payments were charged to active employers, but not matched by  commensurate tax revenue.
One of the states we contacted—California—has an alternate measure of  such shared costs. Under the state’s reserve ratio method of experience  rating, the California Employment Development Department keeps track  of annual increases in negative balances for employers that have negative  balances. Each year, these increases to the negative balance are totaled  and are distributed to all firms in the UI system.
section_title: Benefits Charged to Inactive Firms
paragraphs: State unemployment programs also pay benefits to unemployed workers  whose former employer has gone out of business. In the event that the  state cannot collect commensurate tax revenue from these firms, the costs  of such benefit payments—known as inactive charges—must be borne by  the UI system, and ultimately by all other active firms. In 2004, inactive  charges ranged from 0.2 percent of benefits in Massachusetts to   19.5 percent of benefits in Nevada.
section_title: Noncharged Benefits
paragraphs: In some situations, state unemployment insurance programs will pay  noncharged benefits, that is, benefits paid to unemployed individuals but  not charged to the firms for whom the employees had worked. Because  these benefit payments are not associated with an individual employer,  they become the common burden of employers in state UI systems.  Noncharged benefit payments are allowed partly because of the belief that  an employer should not be charged for unemployment for which the  employer was not responsible. For example, many states pay  unemployment benefits to a worker who voluntarily quits a job and has  not found another job after some interval, or under certain conditions,  such as compelling personal reasons not attributable to the employer.  Policies regarding noncharging of benefit payments vary from state to  state. In addition to voluntary resignations, common types of noncharges  include benefits paid to employees who were discharged for misconduct  and benefit payments made in situations where the benefit award is finally  reversed. A few states will not charge unemployment benefits paid to a  worker hired to replace a member of the armed services called into active  duty and laid off upon the service person’s return.
Noncharged benefits can amount to a significant portion of total benefit  payments. In 2004, noncharged benefits in the states ranged from about   3 percent of total benefit payments in Colorado and New York to about   32 percent in Maine. In 2004, noncharged benefits exceeded 10 percent of  total benefit payments in 34 states and over 20 percent of total benefits in  7 states. Nationally, from 2001 to 2004, noncharges averaged between   10.0 percent and 13.3 percent of all benefits paid.
section_title: Method of Assessing Solvency and Social Cost Surcharges Affects Experience Rating
paragraphs: In order to maintain the solvency of the state unemployment insurance  fund, state unemployment insurance agencies must collect tax payments  to cover shared costs, and must implement some technique of distributing  this tax burden among employers that pay in to the fund. States have  considerable flexibility in doing so, and our contacts with 5 states  indicated that practices may differ widely. Four of the 5 states that we  contacted—California, Michigan, Texas, and Washington—implement tax  rate adjustments specifically designed to distribute and recapture shared  costs, and each of the 5 implement adjustments in response to changes in  the state UI fund.
Tax rate adjustments—whether to recoup shared costs or to ensure fund  solvency—can have an effect on the degree of experience rating. For  example, Illinois makes two adjustments to employers’ experience-rated  tax rates—the state experience factor and the fund-building rate. Because  the state experience factor is multiplied by the employer’s basic tax rate as  determined by an employer’s benefit ratio, the relationship of the tax rates  among all employers does not change. On the other hand, Illinois also adds  a fund-building surcharge—in 2005 the fund-building rate was 0.9 percent  (or $94.50 per employee)—to each employer’s tax rate. Because this  amount is a flat add-on to the adjusted tax rate, it distorts experience  rating in that it changes an employer’s experience-rated rate relative to  those of other employers. For example, an employer with a tax rate of   3 percent would now have a tax rate of 3.9 percent, an effective 30 percent  increase. On the other hand, an employer with a 5 percent tax rate would,  with the fund-building component added, now have a tax rate of   5.9 percent—an 18 percent increase. A similar effect could occur in  Michigan, which adds a flat 1 percent to the tax rate of each employer to  recoup the costs of nonchargeable benefits.
section_title: State UI Tax Policies Result in Persistent Cross-subsidization among Firms and Industries
paragraphs: Studies conducted over the past 34 years indicate that some industries  persistently pay less in unemployment insurance taxes than benefits paid  to their former workers, while others persistently pay more. The studies  we reviewed found that such cross-subsidies favor seasonal and cyclical  industries, such as construction and agriculture, forestry, and fisheries,  whereas firms in the finance, insurance, and real estate industry regularly  pay subsidies. Our analysis of more recent data from several states finds  similar evidence of cross-subsidization, with sometimes substantial  differences between taxes paid and benefits received. In addition, research  shows that there is a considerable amount of cross-subsidization among  firms within the same industry. Studies have also found that new firms  that are not yet experience-rated, regardless of industry, tend to pay  subsidies.
subsections: section_title: Cross-subsidization Typically Favors Firms in Seasonal and Cyclical Industries Such as Construction and Agriculture
paragraphs: A series of studies examining data from the 1950s to the late 1990s have  found consistent cross-subsidization among industries in state UI  systems. The studies we reviewed refer to an excess in benefits received  by former workers compared to taxes paid by an employer as a subsidy.  Though these studies used varying methodologies, they have all compared  total unemployment insurance taxes paid by firms in a broad industry  group to total benefits paid to UI recipients from those industries over  time. As table 3 indicates, in many cases, studies of different states and  time periods show the same industries pay or receive subsidies.
According to the studies, certain industries, such as construction and  agriculture, consistently received subsidies, which can be substantial.  Across different states and time periods studied, the construction industry  most consistently paid less in taxes than benefits paid to its former  employees. For example, one study examined industry groups over a   12-year period, from 1980 to 1991, for 22 states and found that the  construction industry received the largest subsidy. To compare the  relative size of subsidies, the study calculated a summary benefit-tax ratio  for each industry averaged across states by dividing benefits received by  total UI taxes paid. The ratio of 1.68 averaged across 22 states indicates a  large subsidy to the construction industry—as a whole, employers in this  industry paid about $1 for every $1.68 in benefits received by their former  workers. A more recent study of Washington state’s UI program also  examined cross-subsidization among industries over an 11-year period and  found the construction industry received the largest subsidy, as indicated  by the benefit-tax ratios reported in table 4. The total taxes paid by  construction firms covered 77 percent of charged benefits over this time  period.
Although cross-subsidization is found to most consistently favor firms in  the construction industry, other industries also tend to benefit. The  majority of these studies found that firms in agriculture, forestry, and  fisheries receive subsidies. As shown in table 4, for instance, the study of  Washington state found that this industry received the second largest  subsidy from 1989 to 1999. Charged benefits exceeded total taxes paid by  about 13 percent. In addition, several of the studies report that firms in  manufacturing and mining industries also tend to receive subsidies. For  example, the mining and manufacturing industries on average received   37 percent and 9 percent more in benefits than in taxes paid, respectively,  according to the study of 22 states.
Conversely, other industries, in particular finance, insurance, and real  estate consistently pay more in taxes than their former employees receive  in UI benefits, according to studies reviewed. Data from all of the studies  that examine cross-industry subsidies and include the finance, insurance,  and real estate sector indicate that firms in this industry pay a subsidy,  which is often substantial. The study which used data from 22 states to  calculate a combined average benefit-tax ratio for each industry concluded  that the finance, insurance, and real estate industry received about half the  taxes it paid in benefits to its former workers, which was the largest  subsidy paid by any industry. While firms in the finance, insurance, and  real estate industry most consistently pay a subsidy to the UI program,  overall, many other industries also tend to pay subsidies, although not in  every state and time period studied. These industries include wholesale  trade, services, retail trade, transportation, communications, and public  utilities.
While some industries tend to receive or pay subsidies over time and in  different states, other industries do not show a consistent pattern. An  industry may receive a subsidy in one state and pay a subsidy in another  state because of differences in the structure of states’ UI programs or the  regional economy. For example, evidence for the service industry may be  inconsistent across states. One study using data for 21 states from 1968 to  1975 found that the service industry tends to receive a net subsidy, while a  more recent study using data for 22 states from 1980 to 1991 found that the  service industry paid almost 32 percent more in taxes than in benefits  received by its former workers. There is also mixed evidence for the  mining industry. Although several studies have found that mining receives  an overall subsidy, a study of the Texas UI program found that this  industry had the highest percentage of firms that are subsidizers.
More recent tax data obtained from three of the five states we contacted  largely parallels the findings of earlier studies. (See table 5.) In two of the  three states, as in the previous studies, construction, as well as agriculture,  forestry, and fisheries received subsidies. For example, in Washington, the  taxes paid by construction firms covered approximately 70 percent of  charged benefits paid to their former employees. In Illinois, the subsidy to  the construction industry was substantial—from 2001 to 2004, firms in the  construction industry, as a whole, paid more than $1 billion less in  unemployment insurance taxes than the unemployment benefit costs  charged to them. In Texas, the construction industry had the highest ratio  of benefits to taxes, indicating that benefits charged were high relative to  taxes paid compared with other industries for the 2-year period. However,  the construction industry actually paid a subsidy in Texas from 2004 to  2005. During this time all industries in Texas paid more in taxes than in  benefits charged to their former employees. Officials from Texas indicated  this was to repay a trust fund deficit, which the state covered with a bond  issuance in 2003.
Our more recent tax data also show a similar pattern with regard to those  industries that paid subsidies. In two of the three states from which we  had data (Texas and Washington), as in the studies reviewed, the finance,  insurance, and real estate industry paid more in taxes than in benefits paid  to its former workers. Other industries that paid subsidies in Illinois and  Washington include utilities, health care and social assistance,  management of companies and enterprises, and accommodation and food  services. (See fig 2. for Washington) Although the mining industry is often  found to receive a subsidy, in Texas this industry paid a subsidy of more  than $56 million from 2004 to 2005.
The persistence of subsidies to firms in industries such as construction  and agriculture, forestry, and fisheries may be caused by the industries’  susceptibility to seasonal or economic cycles that result in layoffs and  push firms to the maximum tax rate. As one study of UI programs in New  England notes, “firms enjoying the largest subsidies tend to face highly  cyclical or seasonal demand for their products.” If this susceptibility  causes firms in industries such as construction or agriculture to  chronically be at the maximum tax rate, the subsidies they receive may not  be recovered by the state. There is at least one anomaly with regard to this  explanation: The retail trade industry is also seasonal in nature but,  according to some studies, pays subsidies. According to one study, a  possible explanation may be that many unemployed workers in this  industry were not eligible for UI benefits. If unemployed workers in the  retail trade industry were only employed for a short time, they may be  unable to receive benefits and their former employer would not be  charged. Aside from the retail trade industry, firms in industries like  finance, insurance, and real estate may consistently pay more in taxes than  benefits paid, because they tend to have more stable or growing  employment and pay the minimum tax rate.
section_title: Studies Reveal That Subsidy Patterns for Broad Industries Do Not Apply to All Firms in an Industry, and New Firms Tend to Pay Subsidies
paragraphs: Using more detailed data, some studies have found cross-subsidization  within industries. While, at the broad level, some industries receive or pay  subsidies, not all subcategories or firms within these industries fit the  pattern of the overall industry. For example, one study found that within  the manufacturing industry, apparel manufacturing receives a subsidy that  is three to four times as great as the benefit-tax ratio of other  manufacturing subgroups. Another study, using data from Texas, found  that, even though the construction industry as a whole receives the second  largest subsidy, the majority of firms within the construction industry paid  more in taxes than benefits received by their former employees. In that  study, approximately 52 percent of construction firms paid a net subsidy.
Research has also shown that the likelihood an individual firm will receive  a subsidy can vary by the age of the firm. In particular, young firms that  are not yet experience-rated are found to pay more in taxes than benefits  received by their former workers. Typically, firms with less than 3 years  of employment history are assigned a standard tax rate or the average  industry rate. One study, using data from Texas, reports that the majority  of such new firms pay a subsidy, although a few of these firms receive  large subsidies. Among firms less than 5 years old, approximately   67 percent pay a subsidy, which is the highest rate of all age groups.  Overall, the author found that young firms and old firms tend to subsidize  firms in the 11- to 20-year age group. In addition, our analysis of recent  data from Illinois also indicates that firms that are not yet experience- rated pay a relatively large subsidy. In Illinois, new employers paid   21 percent more in taxes than benefits received by their former workers  from 2001 to 2004, to the amount of more than $84 million.
section_title: Measures to Improve Experience Rating and Reduce Subsidies Must Be Balanced against Other Goals
paragraphs: States could take various actions to improve experience rating and reduce  subsidies, but state officials and experts indicated that such changes  should be considered in light of other program goals and considerations.  For example, higher maximum tax rates would better balance tax  payments and benefit charges for employers whose former employees  impose high costs on a state’s program. However, according to state  officials and experts, states may also wish to limit the financial liability of  firms under the unemployment insurance system and that for some firms  and industries, higher tax rates might be difficult to bear.
subsections: section_title: Increasing Tax Payments of Subsidized Firms Could Reduce Subsidies but Increase Financial Strain on Some Businesses and Have Other Undesirable Effects
paragraphs: State unemployment insurance programs could improve experience rating  and reduce cross-subsidies by increasing the unemployment insurance  taxes paid by firms that receive subsidies. Among the several ways states  could improve experience rating, some of the key adjustments would be to  raise the maximum tax rate, increase the taxable wage base, or adopt  some combination of these two modifications.A 2003 analysis of the  Massachusetts unemployment insurance program indicates that making an  adjustment can have a substantial effect on closing the gap between  benefits charged to and taxes paid by firms that get a subsidy. Using a  simulation analysis, the study found that using a new tax rate schedule  with higher maximum rates reduces ineffective charges from $978.4  million to $801.3 million, an 18 percent decrease. Further, an increase in  the taxable wage base from $10,800 to $18,000 was found to reduce  ineffective charges—that is, benefit charges to active firms that are not  matched in tax revenue from those firms—from $978.4 million to   $773.6 million, a 21 percent decrease.
U.S. Department of Labor and state officials, as well as unemployment  insurance experts, have noted that measures to improve experience rating  or reduce cross-subsidies involve trade-offs that states would need to  consider. Several unemployment insurance officials and experts have  stated that full experience rating is not desirable, in part because some  firms could not afford to pay the full costs of benefits their former  employees incur. Commenting on the possibility of higher maximum tax  rates, an official with the Texas Workforce Commission told us that firms  that now pay at the highest tax rates include seasonal employers and  employers whose business activities are being taken over by overseas  firms and other declining companies. He noted that some of these  companies are already under financial stress, and some may well have  adjusted their business models based on the assumption of the maximum  tax rate. An increase in the rate could seriously hurt such firms.
States may also face political resistance to such increases. An Illinois  official said that increases to the maximum tax rate would be portrayed by  affected businesses that are already paying at the maximum tax rate as  creating a bad business climate; some might say that such a change would  drive them out of business or force them to relocate out of the state.  Similarly, in a 1996 report to the President and Congress, the Advisory  Council on Unemployment Compensation noted that some employers— especially small ones—that need to lay off workers may find that their tax  rates increase so dramatically as a result of those layoffs that that  additional layoffs become necessary. The report further noted that no  research has been conducted on the potential negative effects of  experience rating.
Reducing subsidies by raising the maximum tax rates or the taxable wage  base may also conflict with particular policy objectives of a state. For  example, officials of the California Employment Development Department  told us that the California unemployment insurance system was  intentionally developed to subsidize two industries important to the  California economy—agriculture and construction. The officials explained  that the California agricultural sector includes not just farms, but  canneries and other associated industries that have large seasonal  fluctuations in demand for labor. When the state’s UI system last  underwent major revision in 1985, there was an emerging need to provide  alternative sources of income so that workers would be available from  season to season. Unemployment benefits paid during the off-season  became an essential part of an agricultural worker’s annual income. The  officials stated that a pattern of a working season, followed by a period of  subsisting on unemployment benefits, followed by another working  season, has become the norm for many of these workers.
Improving experience rating by increasing the taxable wage base might  involve offsetting effects on experience rating. As noted by the Advisory  Council on Unemployment Compensation, a change in the taxable wage  base most directly affects the degree of experience rating by changing the  distribution of employers’ tax rates. Raising the taxable wage base  increases the degree of experience rating for employers at the maximum  tax rate before the increase, and below it afterward. However, if the tax  rate schedule was not adjusted at the same time, raising the taxable wage  base could also reduce experience rating, as it would increase tax  payments by employers who already pay subsidies into the unemployment  insurance system. If the tax rate schedule was modified, some employers  might move to the minimum tax rate, a change that would also limit  experience rating.
section_title: Reducing Noncharged Benefits Would Restrict UI Eligibility or Impose Additional Costs on Employers
paragraphs: Noncharged benefits—benefits payments that are not charged to a specific  employer—detract from experience rating because they are shared—that  is, they are borne to some degree by all employers, thus adding to the  costs of employers who had no responsibility for the unemployment.  Noncharges could be reduced either by reducing benefit payments in such  cases or by charging such benefits to the recipient’s previous employer or  employers. However, each approach has its drawbacks.
Eliminating noncharged benefits would restrict the breadth of coverage of  state unemployment insurance programs. For example, nearly all states  will, in some situations, pay benefits to unemployed workers who  voluntarily quit their last job. Elimination of such benefit payments would  leave such workers uncovered by the unemployment insurance system.  Elimination of benefit payments in some noncharge situations would also  restrict a state’s ability to promote broader policy objectives though the  unemployment insurance system. For example, an official of the Illinois  Department of Employment Security told us that during a 2003 debate  over statutory changes to the state’s unemployment insurance system,  organized labor advocated for a noncharge in the event that a person  became unemployed because of domestic violence. A person might, for  example, be unable to go to his or her former place of work because the  abuser might stalk that person there. In considering how to reduce  noncharges, states are faced with the choice of paying these noncharges or  denying benefits to individuals in such a situation.
On the other hand, charging many noncharges to employers could be seen  as contrary to the experience-rating principle, because, in theory, the  employer was not responsible for the unemployment. Further, state  officials told us that such an action would likely be strongly resisted by  employers. For example, in describing the domestic violence noncharge  mentioned above, an Illinois official said that employers concurred with  the change, but on the condition that individual employers should not be  charged because responsibility for the unemployment would not be theirs.
section_title: Other Actions to Improve Experience Rating
paragraphs: States could take various other measures to improve experience rating  and reduce cross-subsidies. For example, they could improve experience  rating by lowering or eliminating minimum tax rates. This would improve  experience rating for firms that impose little to no cost on the trust fund.  However, a very low minimum tax rate—especially a zero tax rate—could  also have drawbacks. For example officials of the Michigan  Unemployment Insurance Agency noted that the tax rate in their state  could be too low, given that shared costs need to be recovered, and that  the current minimum rate may not be sufficient to ensure that firms at the  minimum rate pay their share. Others have noted that a zero tax rate  would not be consistent with the notion of social insurance, which  requires that an entity receiving coverage pay some premium, even if the  entity imposes no costs on the system.
States could also make other adjustments to improve experience rating,  such as taking into account the time value of money or, in the case of the  reserve ratio state, eliminating the practice of writing off negative  balances. Such actions would better ensure that a firm’s experience rating  reflects the full costs it has imposed on the UI system. However, such  actions might have little effect on the actual tax payments of firms that are  at the maximum tax rate and receive subsidies year after year. Further,  California officials told us that the practice of writing off negative balances  prevented negative balance employers from falling into too deep a deficit  position. Without such write-offs, the employer would have no incentive to  improve its experience rating by reducing its number of layoffs.
section_title: Concluding Observations
paragraphs: Cross-subsidies in state unemployment insurance systems are a long- standing part of the system, and the subsidies occur because  unemployment insurance taxation systems are not fully experience- rated—a fully experience-rated system would ensure that, over time, the  costs that an employer imposed on the unemployment insurance programs  were equal to the taxes it paid. As with other insurance systems, such as  automobile insurance, many of the potential beneficiaries may never  receive benefits, understanding that the premiums paid protect them  should the need for benefits arise. Several aspects of state unemployment  insurance systems cause this shortfall from full experience rating, and  states could improve experience rating and reduce these cross-subsidies  by adjusting these aspects.
In considering measures to increase the experience rating of state UI  systems, it is important to note that stabilizing employment through  experience rating is one of several goals of unemployment insurance. The  program was also established to provide temporary, partial wage  replacement for unemployed workers, and to stabilize the economy  though maintenance of consumer purchasing power in time of high  unemployment. Further, federal law and regulations provide very limited  guidance regarding the degree of experience rating or the acceptable size  of a cross-subsidy. Instead, they have left it to the states to design  financing systems that are experience-rated to one degree or another.
States could nonetheless increase experience rating and reduce subsidies,  but they have chosen to balance these considerations against other policy  goals. For example, all states have chosen to limit the financial liability of  employers by establishing a maximum tax rate. It is possible that the  subsidies arising from these policies provide benefits that extend beyond  those directly subsidized. Subsidized industries may be large employers in  a given state or represent core parts of a state’s economy. Subsidies may  have other intended effects. For example, they may encourage employers  to continue contributing to the system, even if they provide only a part of  the contribution they should make. Under the current framework, state  policy makers decide the appropriate balance between experience rating  and the other policy objectives of a state’s unemployment insurance  program.
section_title: Agency Comments and Our Evaluation
paragraphs: We provided a draft of this report to the Department of Labor for its  review. Overall, Labor agreed with our findings, and noted that the report  provided a succinct analysis of the issues we sought to address. Labor also  cautioned that an emphasis on “full experience rating” may obscure the  fact that employers in the United States pay an amount much closer to the  benefits assigned to them than do employers in any other country. We  concur with this view, and it is in fact consistent with our conclusions. We  also modified the report slightly to reflect these issues more explicitly.  Labor’s formal comments are reproduced in appendix III.
Labor also provided technical comments on the draft report, which we  have incorporated where appropriate.
As arranged with your office, unless you publicly announce its contents  earlier, we plan no further distribution of this report until 7 days from the  date of this letter. At that time, we will send copies to interested  congressional committees and members, and the Secretary of Labor. We  will also make copies available to others upon request. In addition, our  report will be available at no charge on GAO’s Web site at  http://www.gao.gov.
Contact points for our Office of Congressional Relations and Office of  Public Affairs may be found on the last page of this report. GAO staff that  made major contributions to this report are listed in appendix IV.
section_title: Appendix I: Objectives, Scope, and Methodology
paragraphs: Our objectives were to address the following questions:  1.  How have states ensured that individual employers pay unemployment  insurance taxes based on their experience with unemployment, and  what aspects of state unemployment insurance systems limit such  experience rating?  2.  To what extent do employers pay unemployment insurance taxes  commensurate with unemployment benefits paid to their former  employees, and how does this vary by industry?  3.  What steps could states take if they wished to ensure that the taxes  paid by individual firms more closely matched the benefits paid to the  former employees of each firm?
To answer the first and third questions, we reviewed pertinent literature  and interviewed Department of Labor officials, and officials of national  organizations representing the perspectives of business, labor, and state  unemployment insurance agencies, as well as nationally recognized  experts on unemployment insurance. We also conducted in-depth  interviews with representatives of unemployment insurance agencies in   5 states—California, Illinois, Michigan, Texas, and Washington. We  selected these states because they are relatively populous and  geographically dispersed, and because they take different approaches to  ensuring experience rating. We discussed each state’s approach to  financing unemployment insurance benefits, and the implications that  various aspects of these systems had for experience rating and the  existence of cross-subsidies. We also reviewed pertinent documents  describing the unemployment insurance financing systems in each of these  5 states. In addition, we obtained and analyzed the Department of Labor’s  experience-rating index, an annual measure of experience rating in the  state and territorial unemployment insurance programs.
To answer the second question, we identified and reviewed 10 studies  published between 1972 and 2000 that measured how closely taxes paid by  firms and industries matched the benefit costs they imposed. These  studies used a variety of techniques to measure whether some categories  of employers consistently pay more or less in taxes than benefits paid to  their former workers. Two GAO economists reviewed these studies and  determined that they were sufficiently reliable to use in this report. We  confirmed with the U.S. Department of Labor and national experts on  unemployment insurance that these 10 studies constituted the definitive  work done to date on this subject. To supplement these studies, we asked  the 5 states that we contacted to provide data on tax and benefits  payments by industry type according the North American Industry  Classification System (NAICS). Three of the 5 selected states—Illinois,  Texas, and Washington—provided such data for all or some of the years  from 1999 to 2004. We interviewed officials knowledgeable about these  data and determined that the data were sufficiently reliable to include in  this report. Using these data, we developed updated comparisons of the  balance between taxes paid and benefits received for industry groups.
section_title: Appendix II: Example of a State’s Unemployment Insurance Tax Schedules
paragraphs: California determines which of the eight tax schedules to use based on the  balance in the trust fund as a percentage of gross wages reported by all  employers. This calculation establishes the rate schedule used as outlined  in table 7.
section_title: Appendix III: Comments from the Department of Labor
section_title: Appendix IV: GAO Contacts and Acknowledgments
subsections: section_title: GAO Contact
paragraphs: Sigurd R. Nilsen, Director, (202) 512-7215, nilsens@gao.gov.
section_title: Staff Acknowledgments
paragraphs: Patrick di Battista, Assistant Director, and Michael Hartnett, managed this  assignment. Others who made key contributions throughout the  assignment include Sharon Hermes and Dan Meyer. Dan Schwimer,  Pauline Seretakis, Scott Spicer, and Shana Wallace provided key support.
section_title: Related GAO Products
paragraphs: Unemployment Insurance: Enhancing Program Performance by  Focusing on Improper Payments and Reemployment Services.   GAO-06-696T. Washington, D.C.: May 4, 2006.
Improper Payments: Federal and State Coordination Needed to Report  National Improper Payment Estimates on Federal Programs.   GAO-06-347. Washington, D.C.: April 14, 2006.
Financial Management: Challenges Continue in Meeting Requirements  of the Improper Payments Information Act. GAO-06-581T. Washington,  D.C.: April 5, 2006.
Unemployment Insurance: Factors Associated with Benefit Receipt.  GAO-06-341. Washington, D.C.: March 7, 2006.
Trade Adjustment Assistance: Most Workers in Five Layoffs Received  Services, but Better Outreach Needed on New Benefits. GAO-06-43.  Washington, D.C.: January 31, 2006.
Workforce Investment Act: Labor and States Have Taken Actions to  Improve Data Quality, but Additional Steps Are Needed. GAO-06-82.  Washington, D.C.: November 14, 2005.
Unemployment Insurance: Better Data Needed to Assess Reemployment  Services to Claimants. GAO-05-413. Washington, D.C.: June 24, 2005.
Unemployment Insurance: Information on Benefit Receipt. GAO-05-291.  Washington, D.C.: March 17, 2005.
Trade Adjustment Assistance: Reforms Have Accelerated Training  Enrollment, but Implementation Challenges Remain. GAO-04-1012.  Washington, D.C.: September 22, 2004.
Workforce Investment Act: States and Local Areas Have Developed  Strategies to Assess Performance, but Labor Could Do More to Help.  GAO-04-657. Washington, D.C.: June 1, 2004.
Financial Management: Fiscal Year 2003 Performance and  Accountability Reports Provide Limited Information on  Governmentwide Improper Payments. GAO-04-631T. Washington, D.C.:  April 15, 2004.
Workforce Training: Almost Half of States Fund Employment Placement  and Training through Employer Taxes and Most Coordinate with  Federally Funded Programs. GAO-04-282. Washington, D.C.: February 13,  2004.
Workforce Investment Act: One-Stop Centers Implemented Strategies to  Strengthen Services and Partnerships, but More Research and  Information Sharing Is Needed. GAO-03-725. Washington D.C.: June 18,  2003.
Multiple Employment and Training Programs: Funding and  Performance Measures for Major Programs. GAO-03-589. Washington,  D.C.: April 18, 2003.
Unemployment Insurance: States’ Use of the 2002 Reed Act Distribution.   GAO-03-496.  Washington, D.C.: March 6, 2003.
Unemployment Insurance: Increased Focus on Program Integrity Could  Reduce Billions in Overpayments, GAO-02-697 Washington, D.C.: July 12,  2002.
Unemployment Insurance: Role as Safety Net for Low-Wage Workers Is  Limited. GAO-01-181. Washington, D.C.: December 29, 2000.