UNEMPLOYMENT INSURANCE : Financing of Benefits

Prior to the passage of the Social Security Act in 1935, relatively few employees had any type of protection for income lost during periods of unemployment. The act stipulated that a payroll tax was to be levied on covered employers for the purpose of financing unemployment insurance programs that were to be established by the states under guidelines issued by the federal government. Essentially, the federal law levied a federal tax on certain employers in all states. If a state established an acceptable program of unemployment insurance, the state taxes used to finance its program could be offset against up to 90 percent of the federal tax. If a state failed to establish a program, the federal tax would still be levied, but no monies collected from the employers in that state would be returned for purposes of providing benefits to the unemployed there. Needless to say, all states quickly established unemployment insurance programs. These programs (along with a federal program for railroad workers) now cover more than 95 percent of all working persons, but major gaps in coverage exist for domestic workers, agricultural workers, and the self-employed.

There are several objectives of the current unemployment insurance program. The primary objective is to provide periodic cash income to workers during periods of involuntary unemployment. Benefits are generally paid as a matter of right, with no demonstration of need required. While federal legislation has extended benefits during times of high unemployment, the unemployment insurance program is basically designed for workers whose periods of unemployment are short-term; the long-term and hard-core unemployed must rely on other measures, such as public assistance and job-retraining programs, when unemployment insurance benefits are exhausted.

A second major objective of unemployment insurance is to help the unemployed find jobs. Workers must register at local unemployment offices, and unemployment benefits are received through these offices. Another important objective is to encourage employers to stabilize employment. As will be described later, this is accomplished through the use of experience rating in determining an employer's tax rate. Finally, unemployment insurance contributes to a stable labor supply by providing benefits so that skilled and experienced workers are not forced to seek other jobs during short-term layoffs and thereby remain available to return to work when called back.

Financing of Benefits
Unemployment insurance programs are financed primarily by unemployment taxes levied by both the federal and state governments. The federal tax is equal to 6.2 percent of the first $7,000 of wages for each worker, but this tax is reduced by up to 5.4 percentage points for taxes paid to state programs. The practical effect of this offset is that the federal tax is actually equal to .8 percent of covered payroll. A few states levy an unemployment payroll tax equal to only the maximum offset (5.4 percent on the first $7,000 of wages), but most states have a higher tax rate and/or levy their tax on a higher amount of earnings.

No state levies the same tax on all employers. Rather, states use a method of experience rating whereby all employers, except those in business for a short time or those with a small number of employees, pay a tax rate that reflects their actual experience, within limits. Thus, an employer who has laid off a large percentage of employees will have a higher tax rate than an employer whose employment record has been stable.

An employer with "good experience" will often pay a state tax of less than 1 percent of payroll and possibly as little as .1 percent. Other employers may pay a state tax as high as 9 percent or 10 percent. Regardless of the actual state tax paid, the employer will still pay the .8 percent federal tax.

The major argument for experience rating is that it provides a financial incentive for employers to stabilize employment. Those opposed to its use contend that many employers have little control over economic trends that affect employment. In addition, they argue that tax rates tend to rise in bad economic times and, in so doing, may actually thwart economic recovery.

The entire unemployment insurance tax is collected by individual states and deposited in the Federal Unemployment Insurance Trust Fund, which is administered by the secretary of the treasury. Each state has a separate account that is credited with its taxes and its share of investment earnings on assets in the fund. Unemployment benefits in the state are paid from this account. The federal share of the taxes received by the fund is deposited into separate accounts and is used for administering the federal portion of the program and for giving grants to the states to administer their individual programs. In addition, the federal funds are available for loans to states whose accounts have been depleted during times of high unemployment.

Employee Benefits: ADEQUACY OF FINANCING

Social Security and Medicare are based on a system of funding that the Social Security Administration refers to as partial advance funding. Under this system, taxes are more than sufficient to pay current benefits and also provide some accumulation of assets for the payment of future benefits. Partial advance funding falls somewhere between pay-as-you-go financing, which was once the way Social Security and Medicare were financed, and full advance funding, as used by private insurance and retirement plans. Under pay-as-you-go financing, taxes are set at a level to produce just enough income to pay current benefits; under full advance funding, taxes are set at a level to fund all promised benefits from current service for those making current contributions.

All payroll taxes and other sources of funds for Social Security and Medicare are deposited into four trust funds: an old-age and survivors fund, a disability fund, and two Medicare funds. Benefits and administrative expenses are paid out of the appropriate trust fund from contributions to that fund and any interest earnings on accumulated assets. The trust funds have limited reserves to serve as emergency funds in periods when benefits exceed contributions, as in times of high unemployment. However, current reserves are relatively small and could pay benefits for only a limited time if contributions to a fund ceased. In addition, the reserves consist primarily of IOUs from the Treasury because the contributions have been "borrowed" to finance the government's deficit.

In the early 1980s, considerable concern arose over the potential inability of payroll taxes to pay promised benefits in the future. Through a series of changes, the most significant being the 1983 amendments to the Social Security Act, these problems appeared to have been solved for the Social Security program—at least in the short run. The changes approached the problem from two directions. On one hand, payroll tax rates were increased; on the other hand, some benefits were eliminated and future increases in other benefits were scaled back. However, the solutions of 1983 have not worked. Although the old-age and survivors fund will continue to grow for the time being and will be quite large by the time the current baby boomers retire, benefits will then begin to exceed income, and the fund will shrink as the percentage of retirees grows rapidly. Without further adjustments, the trust funds will have inadequate resources to pay claims in the foreseeable future. Current projections indicate that the Social Security trust funds will run out of money in 2037.

Because of an increasing number of persons aged 65 or older and medical costs that continue to grow at an alarming rate, there is also concern about the Medicare portion of the program. Estimates are that its trust funds will be depleted by about 2023. The seriousness of this problem was made clear by the fact that one of the earliest actions of the second Clinton administration was the passage of legislation to help maintain the solvency of the Medicare trust funds for a few additional years, primarily through encouraging additional enrollment in managed care plans and trimming projected payments to HMOs, hospitals, and doctors.

In the broadest sense, the solution lies in doing one or both of the following: increasing revenue into the trust funds or decreasing benefit costs. Possibilities for increasing revenue include the following:

- Increasing the Social Security and/or Medicare tax rate

- Increasing the wage base on which Social Security taxes are paid

- Using more general tax revenue to fund the programs

- Subjecting a greater portion of income benefits to taxation and depositing the increased tax revenue into the trust funds

- Investing all or a portion of trust fund assets in higher-yielding investments than Treasury securities

- Suggestions that have been made for decreasing benefit costs include the following:

- Raising the normal retirement age beyond the planned increase to age 67

- Raising the early retirement age beyond 62

- Lowering the benefit formula so that future retirees will get somewhat reduced benefits

- Lowering cost-of-living increases

- Imposing a means test for benefits

- Shifting more of the inflation risk to workers through the use of separate accounts for all or part of each worker's contributions, thus giving the worker some control over his or her account

- Increasing the Medicare eligibility age beyond 65

- Increasing Medicare deductibles and copayments

- Increasing the Medicare Part B premium for everyone or possibly only for higher-income retirees

- Lowering or slowing the growth of payments to Medicare providers

- Encouraging or requiring Medicare beneficiaries to enroll in managed-care plans

Any single change will clearly offend one important group of voters or another. As a result, any ultimate solution will probably involve a combination of several of these changes so that everyone will bear a little of the pain.