Restoring Solvency to the Unemployment Insurance Fund

Among other functions, the Employment Development Department (EDD) is responsible for administering the Unemployment Insurance (UI) program, which provides weekly payments to eligible workers who lose their jobs through no fault of their own. The UI fund is currently facing insolvency and, absent corrective action, would remain insolvent for the foreseeable future. During the November 2008 special session, the Governor introduced a proposal to restore solvency to the UI fund, which remains under consideration by the Legislature. Below, we provide an overview of the UI program, describe the Governor’s proposal, comment on the proposal, and present an option to lessen its cost and financial impact on employers.

Background

Program Overview. 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.

Program Financing. Employers currently pay a combination of federal and state unemployment taxes on up to the first $7,000 in wages paid to each employee. The federal portion of the tax funds program administration, while the state portion funds benefit payments. Effectively, employers pay a federal tax rate of 0.8 percent as long as the state’s UI program is in compliance with federal requirements. (If the state fails to comply, the federal administrative tax rate increases by 5.4 percent to a total of 6.2 percent.)

The actual state tax rate for each employer depends on two factors (1) the health of the UI fund and (2) the past utilization of the UI program by that employer’s workers. With regard to the former, current law establishes a series of eight contribution rate schedules ranging from “AA” to “F+,” with each rate schedule tied to various potential conditions of the UI fund. The rates can vary widely due to these factors. Schedule AA (with the minimum employer contribution rate of 0.1 percent) is used when the fund condition is most healthy. Schedule F+ (with a maximum contribution rate of 6.2 percent) is used when the fund condition is extremely weak (approaching or in deficit). When the economy is healthy and unemployment is low, the UI fund balance tends to increase and lower rate schedules, such as “A,” are typically used to determine specific tax liabilities. When the economy softens and unemployment rises, the UI fund condition tends to deteriorate resulting in the use of higher tax rate schedules such as F+.

Within each rate schedule, the specific rate paid by each employer depends on the record of its employees in claiming UI benefits. This record is known as an “experience rating.” Employers with a cycle of growth and contraction (such as the construction industry) pay at the higher end of each rate schedule, while employers with more steady employment trends (such as the retail trade) typically pay at the lower end of the schedules.

Employment Training Tax. In addition to the regular UI taxes, employers pay the Employment Training Tax (ETT), a 0.1 percent tax on the taxable wage base of $7,000 per employee. The ETT generally only applies to employers with positive UI reserve account balances, which means that the employers subject to this tax are those that have generally paid more in UI taxes than their former employees have received in UI benefits. The ETT provides funds to the Employment Training Panel (ETP), which awards training funds to employers in targeted industries to train their workers.

Statutory Benefit Level. State law establishes benefit levels to be paid to unemployed workers. The current maximum weekly benefit is $450. To qualify for benefits in California, a claimant must have generally earned at least $1,300 during one quarter of the most recent year.

Recent Benefit Increases. From 1992 through 2001, the maximum weekly benefit for UI was $230 a week for 26 weeks. Benefits were also limited to 39 percent of wages earned (referred to as wage replacement) in the base period, subject to the cap of $230. 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, with the current maximum weekly benefit of $450 set in 2005. Chapter 409 also increased wage replacement from 39 percent to 45 percent effective January 2002, and to 50 percent effective January 2003. 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 rate schedules.

UI Fund Was Briefly Insolvent in 2004. In 2004, the EDD projected that the UI fund would experience a deficit and end the year with a shortfall of about $1.2 billion, despite the use of the highest tax schedule for employers. As a result, the state obtained its first UI loan from the federal government and borrowed money for April and May of 2004. This loan was completely repaid in May 2004. As we describe further below, federal loans are generally interest–free when repaid within a federal fiscal year (which begins each year on October 1). Therefore, the state was not obligated to pay any interest for this loan. As the economy subsequently improved, the UI fund was able to slowly build up reserves, although the fund did not become healthy enough to move employers off the F+ schedule. As we describe below, the recent decline in the economy has now dramatically changed the financial condition of the UI program.

UI Fund Condition Has Deteriorated

In May and October of each year, EDD reports to the Legislature on the status of the UI fund. The May 2008 report indicated that benefit payments would exceed total receipts during 2008 and 2009, and that the UI program was projected to have a shortfall of $257 million by the end of the 2009 calendar year. The EDD’s October 2008 report, however, indicated that the UI fund’s condition had deteriorated more quickly than anticipated due to the worsening economy. Specifically, EDD now projects a deficit as early as the first quarter of 2009, with a shortfall of $2.4 billion at the end of 2009, which will increase to $4.9 billion by the end of 2010.

We note that these deficit estimates assume unemployment rates of 6.6 percent, 6.7 percent, and 6.5 percent for 2008, 2009, and 2010, respectively. Our economic forecasts indicate higher average unemployment rates of 7.3 percent, 9.3 percent, and 9.5 percent for 2008, 2009, and 2010, respectively. In fact, by December 2008, the unemployment rate for California had already reached 9.3 percent. This means that the shortfalls in the UI program are likely be even greater than projected by EDD.

Federal Loan Means No Interruption In Benefit Payment

Federal Loan. Because of the UI fund’s situation, EDD has already obtained a federal loan to cover the projected deficit in the first quarter of 2009. The federal loan will permit California to make payments to UI claimants without interruption. As requests for federal UI loans must be made on a quarterly basis, EDD will submit another loan request in March 2009 to cover the second quarter of 2009.

Repayment. As we noted above, federal loans that are repaid within a federal fiscal year are generally interest–free. However, federal loans that carry over from one federal fiscal year to the next will generally be assessed interest charges of 4.6 percent per year on the outstanding balance. The principal amount of any funds borrowed are repaid automatically to the federal government from the UI fund whenever the fund has a positive balance. However, interest charges may not be paid out of the fund and must be paid separately by states from another source.

Estimated Interest Costs. Absent corrective action, EDD estimates that the payment due to the federal government for interest for the borrowing period ending September 30, 2009, will be about $20.2 million. It further estimates that the payment for interest for the borrowing period ending September 30, 2010, will be approximately $133.5 million. If the Governor’s proposal to correct the problem, which we describe further below, were adopted, interest costs for the period ending in September 2010 would decrease to an estimated $65.3 million. We note that the actual interest costs are likely to be significantly higher than estimated by EDD because they are based on the department’s now–outdated projections of the unemployment rate.

Technically, the Governor proposes to use special funds to make the interest payment due to the federal government in September 2009. However, because any balances in these special funds are swept to the General Fund at the end of the state fiscal year, the interest payments are effectively paid from the General Fund. In addition, the administration proposes to add statutory language to the 2009–10 Budget Bill to further tap these special fund sources in the event that the state’s interest obligations to the federal government were to increase.

Potential Federal Consequences. The consequences of failure to pay the interest owed on the federal loan are so severe that the state has no practical alternative but to make the payment. This is because, as we noted earlier, California employers would face a 5.4 percent increase in their federal UI taxes, which would trigger the equivalent of a UI tax increase on employers of approximately $6 billion annually. In addition, the state would lose all UI administrative funds from the federal government, which currently amounts to about $360 million, until the interest has been paid. Absent these federal funds, UI administrative costs would most likely be backfilled by the General Fund.

The state also faces serious long–term consequences if it fails to remedy the underlying problem that resulted in this borrowing of funding for the UI system. Specifically, states must demonstrate progress toward restoring solvency to their UI funds within two years of receiving a federal loan, in order to retain the 0.8 percent rate and avoid a 5.4 percent federal UI tax increase, pursuant to federal law.

Governor’s Proposal for Restoring Solvency

The Governor proposes several changes, commencing January 1, 2010, to both the revenue and benefit sides of the UI program to restore solvency to the UI fund. The Governor proposes no changes to the UI program for calendar year 2009 so as to avoid having a financial impact on employers and UI claimants during the recession. We note that although midyear changes in both tax rates and benefits are possible, each poses administrative difficulties. Therefore, the Governor’s proposal to implement changes starting on January 1, 2010 is reasonable in that it minimizes the administrative impact on employers.

The key features of the Governor’s proposals include:

• Increasing the taxable wage base from $7,000 to $10,500 per employee.
• Increasing the tax rates on each of the tax schedules, which would increase the maximum tax rate from 6.2 percent to 8.1 percent.
• Reducing the wage replacement rate from 50 percent to 45 percent.
• Increasing the minimum eligibility to qualify for benefits, which would increase the amount a claimant must generally earn in the highest wage quarter in a 12–month base period from $1,300 to $3,200.
• Increasing the penalty for individuals disqualified from UI benefits for quitting work without good cause or being terminated from work with good cause.

Impact of Governor’s Proposal. The administration estimates that these proposed changes to the UI program would (1) increase employer contributions by approximately $4.1 billion in 2010 and (2) decrease benefit payments by about $300 million. Figure 5 outlines the major revenue and benefit policy changes and their estimated impacts on the UI fund, as well as on employers and workers.

LAO Analysis: Governor’s Proposal Has Merit

Governor’s Proposal Achieves Fund Solvency. We believe the Governor’s proposal has merit in that, based on the available economic data, it brings the fund back into solvency. The state would still have to request a federal loan to cover benefit payments for part of 2010, but the UI fund is estimated to be solvent by the end of 2010, with a balance of about $122 million. In addition, the proposed changes are estimated to increase the fund balance to about $3.1 billion by the end of 2011. Therefore, even with a longer recession and higher unemployment rates, we believe the administration’s proposed changes would likely restore solvency to the UI fund by late 2011.

We also find the administration’s approach to be reasonable in that it brings employer contribution and employee benefit levels more into balance, both with each other and relative to other states’ UI programs, as we elaborate below.

On the revenue side, California’s maximum tax per employee is currently $434 per year, compared to an average of $995 for the nation as a whole. Under the Governor’s proposal, the maximum tax charged per employee per year would increase to about $851, which would bring the tax closer to the average cost in other states.

With respect to benefits, California’s maximum weekly benefit for UI claimants is currently $450, which is a little above the average maximum weekly UI benefit of $409 for all states. Under the Governor’s proposal, the maximum weekly benefit amount would not change, although changes in the minimum eligibility requirement and wage replacement rate would eliminate or reduce benefits for some workers, as described in Figure 5. Approximately 29,700 workers would no longer be eligible for UI benefits, and an estimated 396,000 workers would see an average weekly benefit decrease of about $23.

Eliminate ETT as a Way to Lessen the Impact on Employers

Under the Governor’s proposal, EDD estimates that employers will face a total tax increase ranging from $56 to $417 per employee per year based on the employer’s experience rating. Because the ETT is also based on the taxable wage base, an increase in this base from $7,000 to $10,500 would increase the ETT that employers pay by $3.50 per employee per year, for a total of $10.50 per employee per year. This would result in an increase of about $30 million in revenue from the ETT, bringing the total annual ETT revenue to about $112 million.

As we previously mentioned, the majority of ETT revenue is appropriated to the ETP to provide training funds targeted to specific industries. The ETP consists of an eight–member board that meets monthly to review and approve training contracts for employers who wish to train their workers. Employers develop and submit applications for training projects, which ETP generally awards based on targeted priority industries. These priority industries include green technology, manufacturing, health care, construction, and logistics. The contract terms for awarded projects last 24 months, during which ETP staff monitor performance and incrementally fund training projects that meet established goals. Currently, an estimated 80 percent of businesses pay the ETT, yet relatively few are awarded training grants.

Employers would face a substantial increase in UI taxes under the Governor’s proposal. To partially offset this tax increase, we recommend that the Legislature eliminate the ETT. Employers would collectively retain approximately $112 million that they would otherwise pay in ETT over the course of a year. During hard economic times, we believe it makes sense to partly offset the negative impact on employers of taking the unavoidable and necessary steps to restore solvency to the UI fund. We also question the premise of the ETP program. We believe that private businesses know their training needs better than any state entity could. Letting employers decide how much to spend for the training of their workforce is more efficient than having an appointed board make this decision for them.