Who Killed Unemployment Insurance?

It’s an Orient Express Kind of Situation

This is Part 5 of a serial posting of my law review article, “How to Save Unemployment Insurance.” Catch up on Part Four here. You can download the whole manuscript here.

In some senses the explanation for how UI has come to this pass is depressingly familiar. UI’s structural problems closely resemble the institutional and political problems that have bedeviled U.S. infrastructure spending, as well as those that discourage state and local governments from establishing “rainy day funds” or adequately contributing to their employee pension funds.[1] A few unique features of UI further contribute to its malaise.

Federalism is the root of most of UI’s failings. The decision to finance and administer UI mostly at the state level was based in politics, not policy. As other commentators recognize, modern theories of fiscal federalism predict that states will systematically underinvest in UI, and there is direct historical evidence to support those predictions.[2]

Briefly, the problem is a mismatch of taxes and benefits. UI’s benefits spill over across borders.[3] … At the same time, the legal incidence of UI taxes fall on businesses, many of which could readily relocate to a jurisdiction with lower rates. In the long run the economic incidence of these taxes is mostly shifted to workers, but that in part reflects the greater elasticity of employer decisions, including decisions about where to locate.[4] …

The result is a race to the bottom.[5] States that aim to offer generous UI benefits must fund them, and risk driving out employers, triggering unemployment, which must be funded through higher taxes on the remaining businesses. As the U.S. Supreme Court noted when it considered the constitutionality of the UI system, this is precisely what happened in the 1930s when states attempted to establish their own UI regimes.[6] Even in the absence of actual exit by businesses, the shadow of exit creates unrelenting political pressure to hold taxes low.[7]

Federal efforts to shore up inadequate state financing likely have compounded the problem of state under-investment.[8] Again, states with insufficient balances in their own Trust Fund accounts can borrow against the national Fund, in effect a guaranteed bailout for bankrupt trust fund accounts. The resulting moral hazard encourages states to underfund their own accounts. The UI system’s penalties on excessive state borrowing have been ineffective at curbing this moral hazard problem. A clever, albeit accidental, feature of the penalty system is that it is imposed directly on employers. [9] … What is less clever is the failure to index the penalty for inflation.

To the extent that federal penalty provisions have had any impact, they appear to have further pushed states to squeeze benefits.[10] Again, federal incentives for trust fund solvency could be satisfied either with higher taxes or benefit cutbacks. Many states have pursued both, and some benefit cuts alone, but none have only raised taxes. [11] Further, as penalty provisions have lapsed, states have rescinded their tax increases, but left in place provisions that tend to limit the availability of benefits.[12] Indeed, the Advisory Council on Unemployment Compensation found that federal incentives for state fiscal solvency were a contributing cause of state benefit cuts in the 1980s.[13]

A second critical issue for UI, which also affects the usefulness of the current penalty structure, is time. Very simply, putting money in a trust fund is costly now, while the rewards of paying out benefits generally do not arise until the next deep recession. … If state officials behave myopically, and assign greater value to immediate pain or rewards than to future incentives of similar present value, then an incentive system that fails to account for that present bias will significantly under-incentivize savings.

Fiscal myopia is a well-documented phenomenon in many other contexts. Anyone who has driven recently across a U.S. bridge, or enjoyed its fine system of vintage 1970s air-traffic control, can appreciate American underinvestment in long-term infrastructure.[14] Most states do not make adequate contributions to their budget stabilization or “rainy day” funds, even though that is the normatively ideal tool for borrowing-constrained governments to deal with the business cycle.[15] States underfund public employee pension funds, and charge inadequate premia to cover likely claims in most of their public disaster-insurance programs.[16] In each of these contexts, there is at least some reason to doubt a full federal bailout, suggesting that short-sightedness, and not simply moral hazard, is at work.[17]

Together, federalism and myopia help to explain many of the UI outcomes we’ve seen.[18] States keep trust funds low because they do not value the ability to pay benefits in the future. Based on myopia alone, a preference for low trust funds could drive either low taxes or very generous current benefits. Federalism, however, encourages states to strongly prefer low tax rates over high payouts, since there is far more economic and political pressure from mobile and well-organized businesses than from scattered, relatively immobile, population of individual workers.[19]

One last federal factor that might play some role is the federal taxation of UI benefits. Once more, prior to the early 1980s, UI benefits were tax-free to the beneficiary. Now, however, when a state raises a dollar in tax revenue for its trust fund, it can deliver only 1 — t (the beneficiary’s federal marginal rate) dollars in benefits. In effect the federal government is taxing state savings. Of course, taxing something is usually an excellent way to discourage its production, and it is hard to understand why that would be a desirable outcome here.[20] Taxing benefits encourages states that seek to balance their trust funds to cut benefits instead of raising UI taxes; after all, each dollar of tax cut delivers $1 of value to constituents, while each dollar of benefits lost costs constituents only 1 — t dollars.

Next: No one knows how to fix UI.

[1] See Galle & Stark, supra note 9, at 616 (comparing rainy day funds to UI Trust Funds).

[2] ACUC, supra note 6, at 27–28; Mashaw, supra note 79, at 3–4.

[3] ACUC, supra note 6, at 10.

[4] See generally Patricia M. Anderson & Bruce D. Meyer, The effects of the unemployment insurance payroll tax on wages, employment, claims, and denials, 78 J. Pub. Econ. 81 (2000).

Employers can claim a federal deduction for their state UI taxes, however. IRC § 164; IRS Pub. 535 § 5.

[5] ACUC, supra note 6, at 28; Bassi & McMurer, supra note 13, at 82–83.

[6] Charles C. Steward Machine Co. v. Davis, 301 U.S. 548, 586–88 (1937)).

[7] Bassi & McMurer, supra note 13, at 82; see William W. Bratton & Joseph A. McCahery, The New Economics of Jurisdictional Competition: Devolutionary Federalism in a Second-Best World, 86 Geo. L.J. 201, 264–65 (1997) (making this point about state fiscal competition generally); Gillette, supra note 147, at 966 (2008) (same).

[8] ACUC, supra note 6, at 12; Galle & Stark, supra note 9, at 616–17.

[9] In all likelihood, though, this design choice was the product of legal rules, not political-theory insights. In the 1930s it was unclear if the federal government could constitutionally enact a tax or other financial incentive whose legal incidence fell on states; imposing taxes on employers was seen as more likely be sustained by the Supreme Court. Katherine Baicker, Claudia Goldin & Lawrence F. Katz, A Distinctive System: Origins and Impact of U.S. Unemployment Insurance, in The Defining Moment: The Great Depression and the American Economy in the Twentieth Century 227, 240–41 (Michael D. Bardo, Claudia Goldin & Eugene N. White eds., 1998).

[10] Bassi & McMurer, supra note 13, at 69.

[11] GAO, supra note 12, at 19–24; Leachman et al., supra note 3, at 11.

[12] U.S. General Accounting Office, supra note 88, at 4–5.

[13] ACUC, supra note 6, at 2, 6.

[14] Rosabeth Moss Kanter, Move: Putting America’s Infrastructure Back in the Lead 221–258 (2015); P.O. Demetriades & T.P. Mamuneas, Intertemporal Output and Employment Effects of Public Infrastructure Capital: Evidence from 12 OECD Countires, 110 Econ. J. 687, 687–710 (2000)

[15] David Gamage, Preventing State Budget Crises: Managing the Fiscal Volatility Problem, 98 Cal. L. Rev. 749, 766–67 (2010); Russell S. Sobel & Randall G. Holcombe, The Impact of State Rainy Day Funds in Easing State Fiscal Crises During the 1990–1991 Recession, Pub. Budgeting & Fin. 28, 33 (1996).

[16] Barbara A., Chaney, Paul A. Copley, & Mary S. Stone, The effect of fiscal stress and balanced budget requirements on the funding and measurement of state pension obligations, 21 J. Accounting & Pub. Pol’y 287, 288–313 (2002); J. David Cummins, Should the Government Provide Insurance for Catastrophes?. 88 Fed’l Reserve B. of St. Louis Rev. 337, 358–60 (2006); Amy Monahan, State Fiscal Constitutions and the Law and Politics of Public Pensions, 2015 Ill. L. Rev. 117, 123.

[17] Kunreuther & Pauly, supra note 162, at 106.

[18] The combined role of federalism and myopia helps to explain why the UI system has failed while another seemingly similar system, workers’ compensation, has not. See Baicker, Goldin, & Katz, supra note 149, at 227, 235 & n.18 (questioning why there should be a race to the bottom for UI and not workers’ comp). Although WC is also funded at the state level, it is not subject to the huge recession-driven swings in demand for benefits, and so does not require nearly the degree of savings for the future.

[19] Galle & Stark, supra note 9, at 612–15.

[20] William Baumol, & Wallace E. Oates, The Theory of Environmental Policy 14–35 (2nd ed. 1998).