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. 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. 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. 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. 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.