LAO 2005-06 Budget Analysis: General Government

Analysis of the 2005-06 Budget Bill

Legislative Analyst's Office
February 2005

Employment Development Department (7100)

The Employment Development Department (EDD) is responsible for administering the Employment and Employment Related Services (EERS), the Unemployment Insurance (UI), and the Disability Insurance (DI) programs. The EERS program (1) refers qualified applicants to potential employers; (2) places job-ready applicants in jobs; and (3) helps youths, welfare recipients, and economically disadvantaged persons find jobs or prepare themselves for employment by participating in employment and training programs.

In addition, the department collects taxes and pays benefits under the UI and DI programs. The department collects from employers (1) their UI contributions, (2) the Employment Training Tax, and (3) employee contributions for DI. It also collects personal income tax (PIT) withholding. In addition, it pays UI and DI benefits to eligible claimants.

The budget proposes expenditures totaling $11.6 billion from all funds for support of EDD in 2005-06. This is a decrease of $550 million, or 4.6 percent, below current-year estimated expenditures. This decrease is primarily due to lower costs in the UI program. The budget proposes $19.2 million from the General Fund in 2005-06, which is unchanged from the current year.

Update on the UI Insolvency

Recent economic growth and the corresponding modest increase in employment have substantially reduced the projected deficit in the Unemployment Insurance (UI) fund. We review the UI fund condition, the status of the state's federal loan, and the need for legislative action. 

Program Background. The UI program is a federal-state program, authorized in federal law but with broad discretion for states to set benefit and employer contribution levels. The program is financed by unemployment tax contributions paid by employers for each covered worker. The UI program provides weekly unemployment insurance payments to eligible workers who lose their jobs through no fault of their own. To be eligible for benefits, a claimant must be able to work, be seeking work, and be willing to accept a suitable job.

State law establishes benefit levels to be paid to unemployed workers. The current maximum weekly benefit is $450. Employers pay unemployment taxes on up to $7,000 in wages paid to employees. The actual tax rate for each employer depends on the past utilization of the UI program by the employer's workers. (For a more detailed description of program benefits and financing, please see our Analysis of the 2004-05 Budget Bill, page F-93.)

The Recent Insolvency. In April 2004, the UI fund became insolvent and the state borrowed $214 million in federal funds in order to pay benefit claims. The loan was repaid in May 2004, a typically high revenue period for the UI fund. Although the Legislature provided EDD with the authority to pay interest on the federal loan, no interest payments were necessary during 2004. This is because federal loans repaid within a federal fiscal year are interest free. (Had the fund become insolvent during the fourth quarter of 2004 requiring subsequent borrowing, the interest would have been due to the federal government. The Legislature provided EDD with budget authority to pay interest had this been the case.)

What Caused the April Shortfall? Three factors contributed to the 2004 insolvency: (1) an inadequate financing structure, (2) a series of statutory benefit increases enacted in 2001, and (3) an unanticipated period of relatively high unemployment.

First, the basic financial structure (benefit payments and tax rates) of the UI program was not sufficiently healthy towards the end of the 1990s economic expansion. In a well-functioning UI system, an extended period of employment growth and economic expansion should result in healthy fund balances and the lowest possible tax rates (Schedule A). As described more fully in the 2004-05 Analysis, the UI program is financed by employer taxes paid on the first $7,000 of each employee's wages. The tax rate contribution schedules change each year based on the condition of the UI fund. When the fund is strong (low unemployment and correspondingly lower benefit payments), lower tax rate schedules (such as Schedule A) are used. When the fund condition is weak (such as now), higher rate schedules (such as Schedule F+) are used. In 2000, after several years of relatively low unemployment and robust economic growth, the fund condition never improved past triggering Schedule C. In other words, even at the best of economic times, the fund condition reflected only marginal health.

The second contributing factor was a series of statutory benefit increases first enacted in 2001. Chapter 409, Statutes of 2001 (SB 40, Alarcón), provided for a total increase in the maximum weekly benefit of $220 phased in over a four-year period. Specifically, the maximum weekly benefits were scheduled to increase each January to the following amounts: 2002—$330; 2003—$370; 2004—$410; and 2005—$450. Chapter 409 also increased wage replacement from 39 percent to 45 percent effective January 2002, and to 50 percent effective January 2003. Subsequently, Chapter 4xxx, Statutes of 2002 (SB 2xxx, Alarcón), retroactively granted the January 2002 benefit increase (to $330 per week) back to September 11, 2001. Although Chapter 409 nearly doubled the maximum UI weekly benefit from $230 to $450 over a phased-in period, the legislation did not raise the taxable wage base of $7,000 per worker, nor did it increase the tax rates paid by employers. At the time that Chapter 409 was enacted, EDD estimated that it would increase annual costs for the UI fund by about $1.2 billion each year when fully phased in. The expectation was that these costs would be financed by higher employer taxes pursuant to the existing higher tax rate schedules described above. In other words, EDD projected that under the highest F+ tax schedule, the fund would weaken substantially, but would remain solvent.

The third factor was higher-than-anticipated unemployment rates during 2002 and 2003. Essentially, at the time that Chapter 409 was enacted, the forecasts did not contemplate higher-than-normal unemployment in 2002, 2003, and 2004.

In conclusion, higher statutory benefits added to an inadequately financed UI system, in conjunction with higher than anticipated unemployment, resulted in the April 2004 shortfall.

Smaller Shortfalls Now Anticipated Compared to Prior Forecasts. Although the fund experienced a deficit of $214 million in April 2004, previous estimates made in 2004 and 2003 suggested a much deeper problem. Specifically, EDD's April 2004 forecast anticipated a shortfall of $1 billion in the first quarter of 2005, rising to almost $2 billion by the first quarter of 2006. Since that time, fund revenues and expenditures have moved closer toward balance.

In October 2004, EDD issued its new UI forecast. Based on recent economic improvements, this forecast projects a $340 million shortfall in the first quarter of 2005, and a calendar year-end positive balance of just over $130 million. For 2006, EDD anticipates a $600 million shortfall during the first quarter, and a year-end deficit of about $90 million.

The federal loan will allow California to make benefit payments without interruption during 2005, and the loan should be interest free based on the current projections. For 2006, the state may owe interest to the federal government because borrowing could be necessary during both the first and fourth quarters based on EDD's projections. The budget for 2005-06 seeks authority to expend up to $3 million from the contingent fund on federal interest and fees.

Applying the LAO's Economic Forecast to the UI Fund Condition. In reviewing the UI fund condition report prepared by EDD, we found that EDD assumed significantly higher levels of unemployment than we did in our current fiscal forecast. Specifically, we project that during 2005 and 2006, California's unemployment rate would be 5.4 percent and 5.6 percent, respectively, whereas EDD projected the rates to be 6.1 percent and 5.9 percent. We requested EDD to recalculate the UI fund balances in 2005 and 2006 using our unemployment forecast. Based on this approach, the UI fund would have a positive balance of about $550 million at the end of 2005 and $880 million at the end of 2006.

Situation Is Still Precarious. As described above, the UI fund is no longer projected to experience deep deficits. Under EDD's own projection, there will be a modest deficit of $93 million at the end 2006. Under our economic assumptions, the balance would be a positive $880 million. Nevertheless, the situation is precarious. Any economic disruption and corresponding spike in unemployment could plunge the program into insolvency.

Current Situation Unsustainable Through Full Economic Cycle. Although recent economic improvement means that a short-term crisis has been averted, the current UI financing system cannot be sustained over multiple economic cycles of expansion and contraction. During periods of economic recovery, a healthy UI system should allow the state to move away from the F+ tax rate toward lower tax rate schedules. Even if unemployment remains at 5.5 percent or less during 2007and 2008 (as we forecast), the UI fund balances will not move above $2 billion and the state will remain on the F+ tax schedule. Further, the federal government believes that a prudent reserve for the UI fund would be in excess of $8 billion, an amount that is unachievable under the current financing system.

Negative Consequences of Inaction. There are two negative consequences of not addressing the precariousness of the UI funding situation. First, in the short run there is an equity issue for employers related to continued use of the F+ tax rate schedule when the fund condition is weak. Specifically, the F+ schedule means that employers with more steady employment pay more in relative terms than do cyclical employers whose workers use the program more frequently. (For a more detailed discussion of UI tax rate schedules, please refer to our 2004-05 Analysis.) Second, weak balances in the UI program mean that the state has no cushion against falling into another period of insolvency. Protracted insolvency poses two additional costs: interest payments to the federal government and higher federal administrative tax rates for the UI program. For example, New York state's UI program remains insolvent and beginning in 2005, New York employers paid higher Federal Unemployment Tax Act (FUTA) taxes. A prolonged insolvency (more than two years) would have a similar impact on California's FUTA taxes.

Options for the Legislature. In order to return the UI system to a solid financial footing, the Legislature has essentially four choices: (1) increase the taxable wage base, (2) increase the tax rate schedules, (3) reduce benefit payments, or (4) some combination of the previous three options. Unemployment insurance benefit levels and tax rates are policy issues for the Legislature.

Comparison to Other States. Last year, we reviewed benefit levels and tax rates in other states and concluded that California's average benefit was slightly below the U.S. average and that California's taxable wage base was relatively low. Data for 2004 suggest that California's average weekly benefit is now about equal to the national average. No additional data on the taxable wage base by state were available from the U.S. Department of Labor.

Governor's Proposal. The 2004-05 Governor's Budget did not propose a solution to the impending UI insolvency. During 2004, the administration worked with stakeholders from business and labor to arrive at a consensus on UI benefits and taxes in order restore financial stability. However, no consensus was reached on this issue. Although the 2005-06 Governor's Budget seeks authority to expend up to $3 million on federal interest payments and fees, it provides no suggested solution to the fiscal precariousness of the UI fund.

Conclusion. Recent economic improvements mean that California's UI fund has averted a deepening financial crisis. Nevertheless, the current system of benefits and revenues will be difficult to sustain over future business cycles. A recession would quite likely plunge the system quickly into insolvency resulting in interest costs and the potential for higher FUTA taxes on employers. In order to put the UI system on solid financial ground, the Legislature must either reduce benefits, raise the tax base, or some combination of benefit reductions and revenue increases.

Improving Legislative Oversight for Unspent WIA Funds

Because state Workforce Investment Act (WIA) discretionary funds may be used for many purposes, we recommend deleting a proposed provision which would limit the Legislature's authority to set priorities for unexpended WIA funds from prior years.

Background. Each year, 15 percent of the federal Workforce Investment Act (WIA) funds (referred to as discretionary funds) are available to be spent on a range of state workforce employment activities: state administration, statewide initiatives, current employment services programs, and competitive grant programs. (The remaining 85 percent is allocated to local Workforce Investment Boards.) The state discretionary funds are usually in the range of $65 million to $85 million each year. The Legislature appropriates these funds in the annual budget act.

Budget Control Language for Unspent WIA Funds. Budget control language in the 2004-05 Budget Act gives the administration broad authority to expend in the current year WIA discretionary funds which were not spent in the prior year. Specifically, Provision 1 of Item 7100-001-0869 of the 2004-05 Budget Act permits the administration to spend these funds by simply notifying the Legislature without an opportunity for it to review the proposal. This language, which notwithstands Section 28 (which typically governs the use of unanticipated federal funds), is continued in the proposed 2005-06 Budget Bill.

Administration Obtained Budget Authority for $21.7 Million. In December 2004, the Director of Finance notified the Legislature of $21.7 million in unspent WIA funds from 2003-04. Pursuant to the language discussed above, this notification creates expenditure authority for these funds without input from the Legislature.

Provision 1 Is Flawed With Respect to WIA Funds. Provision 1 is actually part of another budget item pertaining to the administration of UI benefits, which is a caseload-driven entitlement program. When the workload for administering UI benefits increases, it is appropriate to increase the corresponding budget authority for administration. However, this logic does not apply to WIA discretionary funds because workload of WIA administration is not caseload driven and WIA-funded programs are not entitlements. On the contrary, WIA funds are for discretionary projects, which the Legislature should have an opportunity to review.

Section 28 Should Apply to Unanticipated WIA Funds. Section 28 governs the expenditure authority for unanticipated federal funds. Specifically, it establishes a process by which the administration notifies the Legislature of the receipt of unanticipated federal funds and provides the Legislature the opportunity to review the administration's proposed use of the funds. It authorizes their expenditure after 30 days notification to the Legislature that four specified conditions have been met. Specifically, under Section 28 the administration must demonstrate unanticipated federal funds (1) will be expended in accordance with state law, (2) are made avail able for a specified purpose, (3) do not entail any state matching commitment, and (4) and must be expended prior to the next budget act. We believe these conditions should be applied to WIA discretionary funds in order to provide the Legislature with the opportunity to review the proposed uses of those funds. Accordingly, we recommend that the Legislature delete the existing Provision 1 of Item 7100-001-0869. This deletion would effectively apply Section 28 to this item, assuring the Legislature that expenditure of unanticipated WIA funds will be consistent with legislative priorities.

Restoring Auditors and Collectors to Increase Revenue

We recommend adding 50 auditor and collector positions to the Employment Development Department (EDD) in order to collect an additional $6 million in General Fund revenues, $2.2 million in Unemployment Insurance fund revenues, and $1.2 million in special fund revenues. This proposal provides a net benefit of $3.4 million to the General Fund. We further recommend adoption of supplemental report language requiring EDD to report to the Legislature on the actual amount of additional revenue collected.

Background. Among other responsibilities, EDD collects from employers the payroll taxes for UI, employee contributions for DI, PIT withholding, and payments to the employment training fund (ETF). Since 1998-99, EDD has lost 165 auditor and collector positions. Most of these reductions were pursuant to Section 4.10 of various budget acts. (Section 4.10 required the administration to achieve statewide departmental savings.) Although other revenue generating positions at the Franchise Tax Board (FTB) and the Board of Equalization were exempted from Section 4.10 reductions, this was not the case at EDD. The Governor's budget proposes to increase staff at FTB in 2005-06 in order to increase tax compliance, and scores additional revenues of $77 million as a result of this effort.

Estimated Additional Revenues. In view of other budget proposals related to tax compliance and the disparate treatment of auditor/collector positions among the tax agencies,we asked EDD how much revenue would be generated if it restored 50 of the lost auditor and collector positions in the budget year. The department estimated that with these additional positions, it would collect a total of $6 million ($2.6 million General Fund, $2.2 million UI fund, $1.1 million DI fund and $0.1 million ETF) in additional revenues during 2005-06. The estimate is based on historical collection experience and appears reasonable. The revenue estimates allow for start-up activities and training during the first half of the fiscal year, and most of the actual revenues would be collected in the latter half of 2005-06.

Estimated Costs. The EDD estimates that the total cost for 50 new auditor and collector positions would be $3.6 million, including salaries, benefits, equipment, and overhead. This cost could be supported by the General Fund and the DI fund. Based on the amount of DI revenues collected, about 30 percent of first-year costs could be allocated to the DI fund. Thus, General Fund costs would be about $2.6 million and DI costs would be about $1 million. (Although the UI fund would benefit from these collections, no costs can be allocated to UI because UI administration funds are capped by the federal government.) The ratio of General Fund revenues to the General Fund costs would be about 2.3 to 1 in the first year rising to roughly 3 to 1 in the second year.

Add Positions, Document Results. Unlike other revenue collection agencies such as FTB, EDD lacks a systematic method for identifying the strongest audit and collection leads with the biggest payoff. While the department lacks the ability to calculate a precise benefit/cost ratio for additional audit and collection resources, we think there is sufficient evidence to warrant funding an increase in these activities. Accordingly, we suggest that the Legislature restore 50 auditor and collector positions and measure the increased revenue that is generated before authorizing any additional positions.

Analyst's Recommendation. We recommend that the Legislature authorize 50 auditor and collector positions at a total cost of $3.6 million ($2.6 million General Fund and $1 million DI fund). This would result in an additional $6 million in General Fund revenues, $2.2 million in UI fund revenues, and $1.2 million in special fund revenues. The net benefit to the General Fund would be $3.4 million. We further recommend that EDD report on the revenues collected from these additional positions. Based on this report, the Legislature would be in a better position to determine whether it would be cost-effective to add more auditor positions. The following supplemental report language is consistent with this recommendation:

By January 10, 2007, the Employment Development Department shall report to the Legislature on the amount of additional revenue generated by the new auditors and collectors added during 2005-06.

Return to General Government Table of Contents, 2005-06 Budget Analysis