The Impact of the Federal Unemployment Insurance Tax Ceiling


As Drs. Daniel Hamermesh and David Scoones point out in their paper, the steady erosion in the share of wages subject to taxation to fund the unemployment insurance (UI) system as led to an increased burden on low-skilled, and therefore low wage, workers: today only 1/3 of all wages are taxed to fund the UI system. Although the unemployment insurance system is nominally structured to increase the amount of tax paid as wages increase, the low level of wages subject to taxation has transformed the program into a de facto lump sum tax on each worker, regardless of earnings. It is a tax which, in general, is only applied to a worker's first $7,000 of earnings, with no tax levied on earnings above this level in some states, and no tax levied on more than $10,000 of earnings in most states.

Since full time workers, even at the minimum wage, can be expected to earn more than $7,000 in a year, a sizable portion of a low-skilled worker's earnings is taxed, while high-skilled workers are effectively taxed at a lower rate. States which just meet the minimum federal requirements levy a tax on 82 percent of full time minimum wage earnings. This ratio falls as earnings rise so that by the time a worker's earnings reach $30,000 (roughly equal to average earnings) only 23 percent of the total is subject to unemployment insurance tax.

Since 1946 the federal wage base for unemployment insurance taxes has been increased three times, from $3,000 up to $4,200 in 1972, to $6,000 in 1978 and to $7,000 in 1983. Indeed, the irregular increases in the federal UI wage base have marked the few reversals, albeit temporary, in the long-term decline in the share of wages which are taxed for the UI program. On an inflation-adjusted basis the real value of this wage ceiling has fallen by close to 65 percent since 1946, so that real dollar parity with the 1946 level would require a taxable wage base of over $19,000 today.

Increasing the federal unemployment insurance wage base would lead to a lower unemployment insurance tax rate and more sharing of responsibility for the burden of funding the program. It would force many states to raise their own tax ceilings and thus reduce the relative cost of low-skill workers. According to Drs. Hamermesh and Scoones' analysis, this reduction in the cost of employing low wage workers would raise the demand for these workers and lead to an increase in their earnings. The increase in earnings would be the result of higher employment levels and higher wage rates. This increase in demand for less skilled workers would have a moderate and equalizing effect on measures of inequality.

Drs. Hamermesh and Scoones find that an increase in the wages subject to the UI tax would lead to a moderate increase in the benefits, and therefore the cost, of the program. Their analysis shows that states whose wage base is affected by a federal increase experience program cost increases approximately 20 percent higher than do states unaffected by the rise in the wage base.

But as they point out, a higher ceiling on taxable wages does not require an increase in program benefits and costs and does not imply "tax and spend" behavior on the part of state governments. Rather, program costs rise because it suits the interests of higher-wage employers and their workers. While all employers have an interest in less costly (and therefore less generous) UI programs, higher-wage employers have historically shown a preference for more, rather than less, experience rating. This preference for experience rating places these employers in conflict with lower-wage employers who tend to prefer less experience rating in the tax structure. Workers, on the other hand, have no such division in their preferences: they universally prefer more generous UI programs, while having an aversion to experience rating (greater experience rating increases the rewards to an employer from contesting a UI award). An increase in the federal wage base leads to a confluence of interest between higher-wage workers and their employers to structure the UI program to meet their needs.

Structure of the Unemployment Insurance System
Unemployment insurance is funded by a payroll tax levied on the wages paid to individual workers. This tax, however, is not levied on the total amount of wages paid to a worker but rather on some portion of them. Since the program is actually run by the separate states, the fraction of wages that is taxed -- the wage base -- varies from state to state. By federal law the wage base cannot be less than $7,000. Eleven states have set their wage base at this level. Half of all states have a wage base of $8,500 (full-time, full-year earnings at the minimum wage) or below. Hawaii, at $25,500, has the highest wage base.

The level of benefits provided by the unemployment insurance program, along with the degree of experience rating, determines the tax rates needed. (Some variation in this is induced by the need to maintain a desired level of reserves or pay down a prior shortfall.) In general, changes in either of these parameters lead to offsetting changes in the tax rate. Nationwide, in 1995, an average 2.5 percent tax was applied to the wage base to fund the unemployment insurance program. Identical revenue levels could have been reached with a tax rate of 0.9 percent on all wages.

The Advisory Council on Unemployment Compensation is required to release its final recommendations on UI reform by February 1, 1996. Its preliminary report in February 1995, containing 26 recommendations for the UI system, failed to include adjustment of the wage base in its recommendations. The wage base is a central feature of the UI program, and its current level imposes an undue share of the funding responsibility on low wage workers. Enhancing entry-level employment begins with reducing the barriers to that employment.