The UI program, which provides weekly benefits to individuals who are unemployed through no fault of their own, was established under the federal Social Security Act of 1935. Although the program is authorized by federal law, much discretion is given to states to set benefit and employer contribution levels.
The UI program is financed by unemployment tax contributions paid by employers for each covered worker. UI taxes have a federal and a state portion—both levied on an anuual taxable wage base of $7,000 in California. The federal portion of UI employer taxes is primarily used to fund administration at the state and federal level. The federal unemployment tax rate is 6.2 percent. However, when the state is in compliance with federal program requirements, California employers receive a credit (known as the Federal Unemployment Tax Act [FUTA] credit) of 5.4 percent, lowering the effective federal tax rate to 0.8 percent. The state portion of UI taxes is used solely to fund UI benefits for unemployed workers in California. State unemployment tax rates vary across years, as well as across employers. State tax rates are set by a series of rate schedules ranging from AA (the lowest rates) to F+ (the highest). A rate schedule is selected annually based on the condition of the UI fund (the account to which state UI taxes are deposited and from which UI benefits are paid). Rates have been set to the highest schedule (F+) since 2004. Currently, the highest state UI tax rate is 6.2 percent.
Weekly Benefits. UI claimants receive weekly benefitpaymentswhich are intended to replace 50 percent of the individual's earnings lost due to unemployment. More specifically, an individual's weekly benefit amount is equal to 50 percent (known as the wage replacement rate) of his/her average weekly earnings during the highest earning quarter in a 12-month base period. Weekly benefits are limited by a statutory maximum ($450) and minimum ($40). The number of weeks a claimant is eligible to receive benefits is based on two factors. First, all UI claimants are limited to a statutory maximum of 26 weeks. Second, total benefit payments made to a UI claimant over the entirety of a claim are limited to 50 percent of the individual’s earnings during his/her base period (referred to hereafter as the base-period wage replacement rate). Once a claimant has received benefits totaling 50 percent of his/her base period earnings, the claimant may no longer receive benefits, even if this limit is reached before 26 weeks. This effectively limits the duration to less than 26 weeks for many claimants.
Eligibility Requirements. All UI claimants must meet both monetary and nonmonetary eligibility requirements. A monetary eligibility requirement is the minimum prior earnings threshold that an unemployed worker must meet to be eligible to claim benefits. More specifically, a claimant must have earned (1) at least $900 in a single quarter, as well as $1,125 total in a 12–month base period or (2) at least $1,300 in any quarter in the base period. Generally, nonmonetary eligibility requirements mandate that claimants must be actively seeking employment and able and willing to work.
California's UI Fund is Insolvent
Primarily as a result of historically high demand for UI benefits during the recent recession, California’s UI fund has been insolvent since January 2009, when benefit payments exceeded the available balance of the UI fund. By the end of 2009, the UI fund deficit totaled $6.2 billion. As of February 2012, the UI fund deficit has grown to over $10 billion. The UI fund deficit is likely to continue to grow through 2014, when it is expected to reach around $13 billion. Absent corrective action, the UI fund is likely to remain in a deficit through 2020 or longer. To continue payment of benefits despite the UI fund deficit, the state has borrowed from the federal government. The state’s outstanding federal loan is currently about $10 billion. Carrying a federal loan balance results in significant ongoing state costs and increased federal taxes for California employers, as described in more detail below.
State Interest Payments on the Federal Loan Are a Significant General Fund Liability. As a condition of carrying a federal loan balance, the state is required to make annual interest payments. The state was required to make its first interest payment of $304 million in September 2011. The 2011-12 Budget Act made this payment from the General Fund but covered the cost to the General Fund with a loan for a like amount from the state’s Disability Insurance (DI) fund (Unemployment Compensation Disability Fund). The state’s next interest payment is due September 2012 and is expected to be $417 million. As federal law does not permit these interest payments to be made from existing UI employer taxes, the cost of these payments falls on the General Fund. These annual interest costs are expected to persist for the foreseeable future, resulting in more than $3 billion in General Fund costs through the remainder of the decade.
UI Fund Borrowing Results in Increased Federal Taxes for California Employers. For each year that the state carries a federal loan balance, the FUTA credit received by California employers (regularly 5.4 percent) is reduced by a minimum of 0.3 percent or about $300 million. For example, after three years the FUTA credit would be reduced by 0.9 percent, resulting in about $900 million in additional employer taxes. In recent years, federal legislation has suspended these FUTA credit reductions. However, in January 2012 California employers were subject to a 0.3 percent reduction, resulting in increased employer taxes totaling $290 million. Employers will continue to face credit reductions every year until the state’s federal loan is repaid—at which time all of the credit reductions will be restored. The proceeds from these increased federal taxes will be used to pay down the principal of the state’s federal loan.
Mismatch Between UI Funding and Benefit Costs Is Not Isolated to the Recent Recession. The inadequacy of UI fund revenues to cover the cost of UI benefits predates the recent recession and associated UI fund insolvency. In our recent report, California’s Unemployment Insurance Program: Gaining Insight Through Interstate Comparisons (October 2011), we examined the adequacy of funding for UI benefits over the past decade. Our analysis found that in eight of the last ten years, California’s UI benefit costs have exceeded revenues into the UI fund, suggesting that California’s UI program has a structural mismatch between its revenues and benefit costs. This structural mismatch appears likely to persist in future years. One likely source of this mismatch is an increase of UI benefits enacted in 2001. Chapter 409, Statutes of 2001 (SB 40, Alarcón), established the benefit levels currently in effect by increasing the wage replacement rate from 39 percent to 50 percent and the maximum weekly benefit from $230 to $450. This increase in UI benefit levels was not accompanied by an increase in UI taxes. The structural mismatch of UI revenues and benefit costs has contributed to a steady decline in the solvency of the UI fund over the last decade. Since implementation of the statutory increase in UI benefits just described, California’s UI fund reserve has not exceeded one-third of the federal minimum standard for solvency.
Potential Federal Reforms Could Improve Solvency of the State’s UI Fund. In our recent report, Managing California’s Insolvency: The Impact of Federal Proposals on Unemployment Insurance (July 2011), we discussed three federal proposals introduced in 2011 that would have positively affected the solvency of California’s UI fund. One of these proposals, put forth by the President, would provide for more timely repayment of the state’s federal loan and put the UI fund on track to build a healthy reserve. To our knowledge, since our report was published in July 2011, none of these proposals has moved substantially closer to enactment. However, we note the President has indicated in his proposed 2013 federal budget that he continues to support the idea of UI reform.
Description of the Governor’s UI Proposals
The Governor’s proposed 2012-13 budget include three UI-related proposals. The Governor proposes to: (1) continue the current-year strategy of covering the cost of the state’s interest payment on the federal loan to the UI fund with a loan from the DI fund, (2) establish a new revenue source for future interest payments on the federal loan, as well as for repayment of DI fund loans to the General Fund in 2011-12 and 2012-13, and (3) increase the minimum monetary eligibility requirement for receipt of UI benefits. In this section, we describe these three proposals in more detail.
Continues Current Year Strategy of Using DI Fund To Cover Cost of Interest Payment on the Federal Loan. As mentioned above, the 2011-12 budget avoided incurring General Fund costs to pay interest on the state's federal loan by borrowing from the DI fund. The Governor proposes to continue this practice to cover interest costs of $417 million in 2012-13. (The administration indicates that more up-to-date information on the applicable federal interest rates suggests that the interest payment may be less than $417 million.) The DI fund is projected to end the current year with a reserve of $2 billion and, when accounting for the loan of $417 million, is projected to end 2012-13 with a reserve of $1.6 billion (about 28 percent of annual expenditures from the fund). Revenues to the DI fund are generated from an employee payroll tax—equal to one percent of wages up to $95,585 in 2012. Generally, the payroll tax rate paid by employees varies based on the balance of the DI fund; however, the Governor's proposal would require the tax rate to be calculated without taking into account reduced reserves resulting from the loan to the General Fund. The DI fund loans to the General Fund in both 2011-12 and 2012-13 would be repaid by a proposed new revenue source that is discussed in the next section.
Establishes a New Funding Source for Interest Payments on the Federal Loan. The Governor proposes to establish a new employer surcharge which would be used to pay interest on the state's federal loan beginning in 2013-14 as well as cover the General Fund obligation to repay the DI fund loans made in 2011-12 and 2012-13. The surcharge would not be used to pay down the principal on the state's federal loan. All employers currently covered by the UI program would be subject to the new surcharge, which would be equal to a specified percentage (set annually by the EDD) of an employer's total UI taxable wages. The surcharge rate would vary each calendar year based on EDD's projection of the state's interest costs in the following year. More specifically, the surcharge rate in a given calendar year would be equal to the state's projected interest costs in that year divided by total taxable wages paid by all employers in the previous year. Revenues from the employer surcharge would not be deposited in the UI fund. Instead the revenues would go to the Employment Training Fund (ETF). This would allow the surcharge to be used solely for interest costs, as opposed to paying down the principal on the state's federal loan. Excess proceeds would be carried as a reserve in the Employment Training Fund and used to reduce the surcharge in the following year.
Increases the Minimum Monetary Eligibility Requirement. The Governor's budget also proposes to increase the earnings threshold an unemployed worker must satisfy to receive UI benefits. Presently, to qualify for UI benefits, an unemployed worker must have earned at least $900 in the highest quarter or $1,300 in any one quarter of his/her 12–month base period. These thresholds have not been adjusted for changes in wage levels since 1992. Under the Governor's proposal, these limits would be increased to $1,920 and $3,200 respectively. The EDD estimates that this change would reduce annual UI benefit payments by $30 million (less than one percent of total annual benefit payments).
Governor’s Proposals Overlook More Significant Issues
As we discussed above, our analysis finds that for much of the past decade UI fund revenues have been inadequate to cover UI benefit costs. In the absence of corrective actions, this mismatch is likely to continue for the foreseeable future. In general, addressing this issue will require (1) increased revenues to the UI fund, (2) decreased benefits paid from the UI fund, or (3) a combination of both. Correcting the mismatch between UI fund revenues and benefit costs will allow the state to repay its current federal loan in a more timely manner. This is because UI fund revenues in excess of benefit costs are dedicated to repayment of the federal loan. It would also build a healthy reserve to protect against the risk of insolvency (and thus more borrowing from the federal government) during future economic downturns.
As discussed above, under current law, California employers will be subject to automatic and gradually increasing federal UI taxes. These federal tax increases would be used to pay down the principal on the federal loan but it would likely take a decade or longer for the loan to be fully repaid. Upon repayment of the federal loan, the federal tax increases would be eliminated and would not be available to build a UI fund reserve to protect against insolvency in the future. The Governor’s proposals would not significantly increase revenues or decrease costs of the UI fund beyond the automatic federal tax increases discussed above. (The Governor’s proposed employer surcharge would be used only to cover interest costs on the federal loan.) For this reason, under the Governor’s proposal, the state would continue to have an extended timeline for repayment of its federal loan and the UI fund would continue to have a long-term structural imbalance. In addition, by taking no action to provide for more timely repayment of the federal loan, the Governor’s proposals concentrate the impact of repaying the federal loan almost entirely on employer costs.
Consider Governor’s Proposals as Part of a Comprehensive Solution
Consistent with our previous reports, California’s Other Budget Deficit: The Unemployment Insurance Fund Insolvency and Managing California’s Insolvency: The Impact of Federal Proposals on Unemployment Insurance, we continue to recommend that, in the absence of federal UI reforms, the Legislature adopt a comprehensive plan to ensure the long-term solvency of the UI fund. We suggest that such a plan be balanced, including both actions on the revenue side (increased employer taxes) and the cost side (decreased UI benefits). We have provided examples of balanced plans in the reports mentioned above. As has been discussed previously, the Governor’s proposals fall short of being a comprehensive plan to address the long-term solvency of the UI fund. However, we find that the Governor’s proposals merit consideration if included in a comprehensive long-term solvency plan. If a future long-term solvency plan included increased employer taxes, dedicating a portion of these increased revenues to making interest payments on the state’s federal loan—in a manner similar to that proposed by the Governor—would avoid significant General Fund costs in future years. Also, we concur with the Governor’s assessment that monetary eligibility thresholds should be updated to reflect changes in wage levels.
We recognize that, in light of uncertainty regarding federal UI reforms and the recovery of California’s labor market, the Legislature may wish to take a wait-and-see approach during 2012 and delay enactment of a long-term solvency plan until next year. Enactment of a long-term plan will likely necessitate significant legislative deliberation and compromise among the various stakeholders of the UI system. For this reason, if the Legislature elects to delay addressing UI fund insolvency, we think that is would be premature to enact the Governor’s proposed employer surcharge and monetary eligibility changes. Under this scenario, we would recommend that the Legislature postpone considering the Governor’s proposals until they can be considered as part of a long-term solvency plan. In the interim, continuing the current-year strategy of borrowing from the DI fund to cover the state’s federal interest payment—creating short-term General Fund savings—is warranted by the state’s fiscal condition.