This post is the third in a series of four posts related to California’s Unemployment Insurance (UI) program. The first two posts reviewed the current condition of the UI trust fund and how it may change in the near future and also provided context on who pays UI taxes and how much they pay. This post assesses the extent to which the UI trust fund is prepared for the next economic downturn. The final post will look at potential steps the Legislature could take should it wish to increase reserves in the trust fund as a means to address the fiscal impacts of the next economic downturn.
The other posts in this series can be accessed using the nearby menu.
UI Program Assists Unemployed Workers. As described in previous posts, the UI program provides weekly benefits, funded through payroll tax contributions paid by employers, to workers who have lost their jobs through no fault of their own. Weekly UI benefits are intended to replace up to 50 percent of a claimant’s prior earnings, subject to a maximum of $450 per week, for up to 26 weeks.
UI Program Is Financed Through Employer Tax Contributions. Employers pay both state and federal UI payroll taxes. State UI taxes are deposited into the state’s UI trust fund to pay for benefits to unemployed workers. Federal UI taxes are typically used to pay for certain costs other than state UI benefit payments, such as program administration; however, as described in our first post, federal UI taxes may be increased to pay off federal loans received by a state to allow benefits to be paid when the state’s trust fund is insolvent. California employers are currently subject to increased federal UI taxes for this reason.
State UI Tax Is Experience-Rated, While Federal UI Tax Is Not. As described in our second post, state UI tax schedules require relatively higher tax rates for employers whose former employees disproportionately receive UI benefits, in an attempt to allocate the costs of UI benefits to those employers whose employees benefit the most from UI. This practice is referred to as “experience rating.” Experience rating in the UI program is incomplete, meaning that there is a cap (6.2 percent) on how high an employer’s state UI tax rate can be. Because the tax contributions of some employers that are assigned the maximum rate do not fully cover the UI benefits received by their former employees, the UI system increases the tax rates assigned to other employers to make up the difference. In this way, some employers subsidize the benefits received by the employees of other employers. The federal UI tax, including any increases imposed in the event that the state has outstanding federal loans, is not experience-rated, meaning that the same tax rate is applied to all employers across the board.
Traditionally, State UI Programs Are Countercyclical. The operations and financing of state UI programs are closely linked to cycles of growth and decline in a state’s economy. During recessions, unemployment is relatively high and more people qualify for and receive UI benefits than during periods of economic growth.
While total UI benefit payments typically increase during a recession, state UI systems typically have less capacity to generate revenues to pay for the above-average benefits. This is because during a recession, taxable wages often decrease (reflecting layoffs and reduced wages), such that a given tax rate produces less revenue. Raising tax rates to generate additional revenue during a recession can be problematic as many employers are already struggling with difficult business conditions. Traditionally, state UI programs have addressed this issue by raising more revenues than are needed to pay for present UI benefit costs when the economy is growing, in order to build up a reserve to pay for higher UI benefit levels during a future recession. This approach can be thought of as “pre-funding” the above-average total benefits that are typically claimed during a recession. In this way, state UI programs are countercyclical by paying above-average benefits during economic contractions (depleting reserves) and raising above-average revenues during expansions (building reserves).
California’s UI Trust Fund Reserves Were Insufficient to Pay Benefits Through Last Recession, Leading to Insolvency. Due to prior legislative action to increase UI benefits without changes to employer taxes and significantly increased levels of unemployment, California’s UI trust fund reserves were not sufficient to pay for a surge in UI benefit payments during the last recession (see our previous post). The trust fund exhausted its reserves in 2009, requiring the state to take federal loans to continue the payment of benefits without interruption. Receiving these federal loans has resulted in the state making General Fund interest payments that will total an estimated $1.4 billion before the federal loans are repaid. (We note that the state was not required to pay interest costs from the General Fund—some other states with federal loans have opted to levy a surcharge on employers to pay interest costs.) As previously noted, the remaining federal loans have also triggered automatic temporary increases in the federal UI taxes paid by employers that go into effect if federal loans remain outstanding for a certain amount of time (between 22 and 34 months, depending on when the loans are first received). The proceeds go to pay down the state’s outstanding loans. These federal UI tax increases escalate each year until the federal loans are fully repaid, at which point they will end. In large part due to the federal UI tax increases, the state has begun to pay down its federal loans. While the state had a loan balance of $10.2 billion at the end of 2012, the total amount of outstanding federal loans was $6.4 billion at the end of 2015.
Trust Fund Projected to Return to Solvency in 2018. If the state’s economy continues to experience moderate growth and no changes are made to the current UI tax and benefit structure, the state is projected to fully repay its current outstanding federal loans sometime in 2018. At that point, the trust fund will be solvent (have a positive reserve balance), and the federal UI taxes paid by employers will return to previous lower levels. In what follows, we describe why the UI trust fund risks returning to insolvency in a future recession, and what implications this could have for the state.
As already noted, the condition of the UI trust fund is closely linked to cycles of growth and decline in the state’s economy. Accordingly, the future condition of the UI trust fund will depend on the path of the economy and the timing and severity of the next recession—variables which are very difficult to predict. In order for the trust fund to avoid returning to insolvency, it must accumulate a reserve balance that exceeds the amount that will be drawn out of reserves to pay for UI benefits in the next economic downturn (the amount by which benefit payments exceed tax contributions over the course of the downturn). To assess the likelihood that sufficient reserves will be accumulated in the context of uncertainty surrounding economic projections, below we present projections for what level of reserves might be achieved under two economic scenarios. First, we project the level of reserves if no recession occurs, and then compare these potential future reserves against the projected impact of a potential future recession.
As Long as State Continues to Grow and Has Low Unemployment, Trust Fund Reserves Will Slowly Accumulate. As long as the state’s economy continues to experience moderate growth with declining or flat unemployment, the UI trust fund will slowly accumulate reserves—after reaching solvency in 2018—as revenues slightly exceed benefit costs. Figure 1 shows Employment Development Department (EDD) projections of future year-end trust fund balances, under a scenario provided by our office that reflects declining or flat unemployment (in other words, no recession) through 2023. These amounts can be thought of as the reserves that would be available to be drawn down during the next downturn. We note that these projections are intended to be illustrative, and represent only one of many possible outcomes, particularly over such a lengthy time horizon.
Potential Year-End UI Trust Fund Reserve Balances Under Declining or Flat Unemploymenta
aThe Employment Development Department projections based on LAO unemployment rate assumptions.
bEmployers are projected to be paying increased federal unemployment insurance (UI) taxes through 2018, resulting in rapid improvement in the trust fund condition in these years. Following 2018, once the trust fund has returned to solvency and currently outstanding federal loans are repaid, increased federal UI taxes would end and trust fund reserves would accumulate more slowly.
Whether Trust Fund Can Remain Solvent Depends on Timing and Severity of Next Downturn. As we have discussed elsewhere, the current economic expansion is among the longest on record. There is a good chance that growth will stall and unemployment will rise at some point before 2023. However, there is no reliable tool to predict the timing or severity of a future recession far in advance. Since reserves are projected to grow while unemployment is declining or flat, the sooner the next downturn takes place, the smaller its effect on reserves has to be to result in insolvency. For example, the trust fund might withstand a future recession that reduces reserves by $3 billion, so long as that recession does not take place prior to the end of 2020. On the other hand, a hypothetical future recession that reduces reserves by more than $4 billion would likely lead to insolvency at any point prior to the end of 2023.
UI Trust Fund Could Remain Solvent in Some Future Recession Scenarios, but Not Others. How much could a future recession be expected to reduce trust fund reserves? EDD projections based on an unemployment rate scenario provided by our office suggest that a recession beginning in 2018 with unemployment levels similar to what was observed in the early 2000s (following the “dot.com” bust) could reduce trust fund reserves over a few years from the 2018 year-end level displayed in Figure 1 by about $1.4 billion—enough to significantly deplete, but not exhaust, the reserves projected to be accumulated by that point. On the other hand, recent history shows that much more significant downturns resulting in much larger reductions in reserves are possible. For example, the most recent recession (which was unusually severe) reduced trust fund reserves over several years by more than $12 billion. Given the significant uncertainty surrounding the timing and severity of the next downturn, it is difficult to say whether the UI trust fund, once it returns to solvency, could remain solvent. There are reasonable scenarios in which it could remain solvent, and there are other reasonable scenarios in which accumulated reserves could again be exhausted.
Building Larger Reserves Would Require Legislative Action. Given the likelihood of an economic slowdown at some point in coming years, these projections suggest that, depending on the severity and timing of future downturns, the trust fund may not be able to build a sufficient reserve to continue paying benefits. In other words, even though the trust fund may achieve solvency in the next few years with current statutory benefit levels and state UI tax rates, it is uncertain whether solvency can be maintained over the longer term. In light of this uncertainty, legislative action would be required in order to build reserves more quickly to ensure solvency in the long term, including some combination of state UI tax increases and/or benefit reductions.
Since the state’s UI trust fund exhausted its reserve in 2009, different plans for increasing trust fund reserves have been considered, but no action has been taken. Since the state’s UI trust fund may not achieve long-term solvency without statutory changes, one question that arises is what the implications for the state would be if the Legislature ultimately takes no action to increase reserves. We discuss some potential implications below.
Loans May be Required in the Future. If the Legislature takes no action, there is a possibility that the UI trust fund reserve will be exhausted again in a future downturn, requiring the state to obtain loans to avoid an interruption in benefit payments. Federal law provides for states—at their option—to receive federal loans to continue the payment of UI benefits, an option the state took during the last recession. We note that the state has the option of issuing debt in private markets, most likely in the form of revenue bonds, to finance UI benefits or “refinance” federal loans, as some other states have done. There are various considerations as to whether issuing debt in private markets to finance UI benefits would be advantageous. A discussion of these considerations is beyond the scope of this post. Consistent with the state’s action during the last recession, we assume that the state would use federal loans to finance benefits in the event of a future insolvency.
Relying on Loans Means Revenue Collection to Pay for Benefit Costs Is Delayed . . . If federal loans are used to pay for benefits in the event that the trust fund’s reserve is exhausted again in the future, the state avoids the need to immediately raise employer contribution rates. The state’s employers would then in effect repay the federal loans as the economy improves and state UI tax revenues later exceed ongoing benefits costs. Ultimately, if the loans remain outstanding for long enough to trigger increased federal UI taxes on employers, the proceeds of these increases would be used to pay off the loans (as is currently the case in California). Since unemployed workers would continue to receive benefits while loans are repaid, employer contributions used to repay federal loans would be above those used to fund ongoing benefit costs.
As described earlier, the traditional approach used in state UI programs has been for trust fund reserves to build by raising more state UI tax revenues than are needed to pay for ongoing benefit costs prior to a downturn. If, however, the state UI tax does not raise enough revenues to build a sufficient reserve, relying on loans will require tax contributions to be higher than benefit costs after a downturn, in order to provide for loan repayment. In other words, because all benefits provided must eventually be paid for, using loans during insolvency simply shifts payment for costs from before the downturn to after. This can be thought of as “post-funding” the above-average benefits that are paid out during a downturn.
. . . Results in Interest Costs . . . However, unlike when UI benefits are pre-funded, the state would incur interest costs when loans are required. The interest costs of federal loans could be paid for from a new surcharge levied on employers (similar to the actions of some states following the last recession) or could be paid from other state resources, such as the General Fund (consistent with how interest on California’s currently outstanding federal loans has been handled).
. . . And May Increase Cross-Subsidies. Finally, as described in our second post, because the federal UI tax is not experience-rated, payment for past benefits through increased federal UI taxes increases the extent to which employers with relatively low benefit costs subsidize employers with relatively high benefit costs.
The Legislature’s decision of whether to take action now to build a larger UI trust fund reserve in preparation for a future economic downturn requires weighing various trade-offs. We summarize these trade-offs below.
Take No Action to Align State UI Tax Revenues and Benefit Costs and Rely on Federal Loans as Needed. Taking no action now avoids increasing the state UI tax or reducing UI benefit levels in the short term, but increases the risk that loans will be required to continue UI benefit payments through a future downturn. The state would face interest costs associated with these loans that could either be paid from the General Fund (consistent with the current practice) or by levying a new surcharge on employers. Finally, this approach could increase cross-subsidies in the UI program if a greater share of revenues are collected through the uniformly applied federal UI tax to repay federal UI loans.
Take Action to Increase Trust Fund Reserves. Alternatively, the Legislature could take action to accelerate the accumulation of trust fund reserves through some combination of revenue increases and/or benefit reductions as noted previously. By making revenue increases and/or benefit reductions in the near term, the Legislature would increase the likelihood that the reserve will be sufficient to cover above-average benefits during the next economic downturn. This alternative, because it avoids the need for UI loans, avoids interest costs. Because benefits would be funded fully from the experience-rated state UI tax, taking action to increase trust fund reserves would allocate a greater share of costs to employers whose employees receive a disproportionately large share of total benefits, reducing cross-subsidization in the UI program relative to what would occur of no such action is taken. In our next post, we describe what actions the Legislature could take if it wished to increase trust fund reserves in advance of the next downturn.