Analysis of the 2004-05 Budget Bill Legislative Analyst's Office February 2004

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. Pursuant to Chapter 859, Statutes of 2002 (SB 1236, Alarcón), which implemented the Governor's Reorganization Plan Number 1, the EDD is part of the new Labor and Workforce Development Agency.

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 withholding. In addition, it pays UI and DI benefits to eligible claimants.

The budget proposes expenditures totaling $12.6 billion from all funds for support of EDD in 2004-05. This is a decrease $840 million or 6.2 percent below current-year estimated expenditures. This decrease is primarily due to avoiding extended benefit costs that occurred in 2003-04. The budget proposes $18.8 million from the General Fund in 2004-05, which is unchanged from the current year. 

No Expenditure Plan For Discretionary Workforce Funds

The Governor's budget does not include an expenditure plan for the federal Workforce Investment Act (WIA) discretionary funds. In order to ensure that the WIA discretionary spending is consistent with legislative priorities, we recommend denying the expenditure authority for these federal funds until an expenditure plan is submitted to the Legislature. (Reduce Item 7100-001-0869 by $16.8 million.)

Background. The federal WIA of 1998 replaced the Job Training Partnership Act, which provided employment and training services. The goal of WIA is to strengthen coordination among various employment, education, and training programs. The 63 member Workforce Investment Board (WIB) advises the Governor on the operations of the state workforce investment system; however, the board's actions are not binding on the Governor.

Pursuant to federal law, 85 percent of WIA funds (an estimated $449 million in 2004-05) are allocated to local WIBs, formerly known as Private Industry Councils. The remaining 15 percent of WIA funds ($67 million) is available for discretionary purposes such as administration, statewide initiatives, current employment service programs, or competitive grants.

Legislative Authority. Although federal law and the Governor's budget refer to these 15 percent monies as "Governor's discretionary" funds, this nomenclature is misleading. Section 191 of the WIA states that all WIA funds "shall be subject to appropriation by the State Legislature." Thus, these WIA funds should be considered state discretionary funds rather than Governor's discretionary funds. Accordingly, the Legislature should review the WIA expenditures to ensure their consistency with legislative priorities.

Legislature Needs Expenditure Plan. The Governor's budget includes no expenditure plan for the discretionary WIA funds. In past years, about 75 percent of the discretionary funds have been used for administration, required WIA activities, and to offset General Fund costs in existing programs. Based on this expenditure history, about $16.8 million in discretionary WIA funds should be available for proposed discretionary programs in 2004-05. Without an expenditure plan, the Legislature cannot exercise its oversight budget review responsibilities over such programs.

Analyst's Recommendation. Until the administration provides a budget plan for discretionary WIA funds, we recommend that the Legislature not appropriate these funds. Accordingly, we recommend reducing the budget authority in Item 7100-001-0869 by $16,800,000.

Setting Priorities for Unemployment Administration

Due to increased workload in combination with recent statewide hiring freezes, the California Unemployment Insurance Appeals Board (CUIAB) is now out of compliance with 2 of 3 federal guidelines pertaining to timely adjudication of cases, and is operating under a federal corrective action plan. CUIAB functions are primarily financed by Unemployment Administration Fund—Federal (UAFF). We recommend that CUIAB report at budget hearings on its progress in fulfilling the requirements of the federal corrective action plan and that EDD report at hearings on the competing uses of the UAFF. In addressing the workload and compliance issues at the CUIAB, the Legislature and administration should set priorities for the competing expenditure obligations for the UAFF.

Background. The CUIAB adjudicates cases involving unemployment insurance, disability insurance, and employment taxes. The EDD makes the initial determination for benefit eligibility or tax liability. The CUIAB administrative law judges conduct hearings in 12 field offices throughout the state and issue decisions on appeals of the EDD determinations. Appeals of the administrative law judge decisions are reviewed by members of the CUIAB.

For 2004-05, the Governor's budget proposes expenditures of $585 million from the UAFF, including $61.5 million for the CUIAB, $177 million for employment services, and $347 million for tax collections and benefit payments administration. Just under 90 percent of CUIAB activities are funded by UAFF.

Workload Increase/Federal Compliance. Recent increases in statewide unemployment have lead to corresponding increases in the UI caseload and the workload at the CUIAB. Further workload increases could occur when the Legislature makes changes to UI benefits and/or tax rates in response to the UI insolvency problem (discussed later in this section). Like most state agencies, the CUIAB is subject to the statewide hiring freeze, and has had limited success in receiving hiring and promotion exemptions from the Department of Finance. Currently, the CUIAB has 126 vacant positions (37 permanent and 89 temporary). As a result, the CUIAB is now out of compliance with two of three federal guidelines pertaining to timely adjudication of cases and is operating under a federally approved corrective action plan.

Competing Priorities for Federal Funds. The UAFF supports the CUIAB as well as other administrative functions at EDD. Any funds not spent in 2003-04 may be carried over to future years. In past years EDD, has used funds from a one-time Reed Act distribution (see the EDD section of the Analysis of 2003-04 Budget Bill for more information on Reed Act funds) to support administrative costs at EDD, thus relieving pressure on the UAFF. Now that the Reed Act funds have been spent, the UAFF may be needed for other EDD programs formerly supported by Reed Act funds.

Analyst's Recommendation. We recommend that CUIAB report at budget hearings on its backlog and its progress in fulfilling the requirements of the federal corrective action plan. We further recommend that EDD report at hearings on the competing needs in other EDD programs for support from the UAFF. In deciding whether to commit more UAFF to the CUIAB, the Legislature needs to weigh the potential benefits of reducing the adjudication backlog at the CUIAB against potential service reductions in other EDD programs.

Restoring Solvency to the Unemployment Insurance Fund

The Unemployment Insurance (UI) Fund will become insolvent in the first quarter of 2004. Absent corrective action, the UI fund will develop a shortfall of $1.2 billion by the end of calendar 2004, rising to $2.3 billion by the end of 2005. Despite the estimated deficit, a recently approved federal loan will enable the fund to make required benefit payments without interruption to UI claimants in the near term. The deficit resulted from a combination of recently enacted benefit increases and higher levels of unemployment associated with the recession. We recap recent changes in the UI program and present alternatives for restoring the UI fund to solvency.

Background

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 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. Current law establishes a series of contribution rate schedules ranging from A to F, with each rate schedule tied to various potential conditions of the UI fund. Schedule A (with the lowest employer contribution rates) is used when the fund condition is most healthy and Schedule F (with the highest contribution rates) is used when the fund condition is weak (approaching a deficit). 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." Cyclical employers (such as construction) pay at the higher end of each rate schedule, while employers with more steady employment (such as retail trade) pay at the lower end of the schedules.

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 E and F. When the fund is under extreme distress, current law authorizes Schedule "F+" which includes a 15 percent surcharge above the rates established in Schedule F.

Statutory Benefit Level. State law establishes benefit levels to be paid to unemployed workers. The current maximum weekly benefit is $410. The amount of benefits available is based on the claimant's earnings in the "base period" which is 12 months. The quarter within the base period in which the highest wages were received generally determines the weekly benefit amount. To qualify for benefits in California, a claimant must have generally earned at least $1,300 in the highest quarter of the base period.

Recent Legislative History. From 1992 through the 2001, the maximum weekly benefit for UI was $230 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. Specifically, the maximum weekly benefits were scheduled to increase each January as follows: 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.

Anticipated Impact of Chapter 409 on the UI Fund. 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. 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.

UI Fund Condition Deteriorates

Required Forecasts. In May and October of each year, EDD is required to report to the Legislature on the status of the UI fund. The October 2002 report indicated that the UI fund balance was declining and expected to reach a low point of just less than $1 billion during the first quarter of 2004. Although the projected decrease was of concern, the October 2002 forecast did not indicate the fund would become insolvent. This changed in the next forecast. In July 2003, EDD released its forecast (due in May) of the UI fund balance, indicating that the fund would experience a deficit during the first quarter of 2004 and would end 2004 with a shortfall of about $1.17 billion. The October 2003 forecast confirms the earlier forecast. Specifically, EDD projects that the deficit at the end of 2004 will be $1.15 billion and increase to $2.31 billion at the end of 2005. These deficits are projected to occur despite the use of the F+ tax schedule in 2004 and 2005.

Tax Rate Schedules. During 2001 and 2002, tax rate schedule C was in effect, and the average tax rate was about 2.5 percent for California employers. The October 2002 forecast indicated that Schedule D would be used in 2003 and Schedule F+ would be needed for 2004. The October 2003 forecast indicates that Schedule F+ will be needed in 2005 as well. According to EDD, the average tax rate is projected to increase to 3.1 percent in 2003 and 4.7 percent in 2004 and 2005, because of the increase to Schedule F+.

Federal Loan Means No Interruption in Benefit Payments

Federal Loan Approved. Because the UI fund was projected to become insolvent, the EDD applied for a federal loan during the fall of 2003. The federal Department of Labor (DOL) approved the loan in December 2003. The federal loan will permit California to make payments to UI claimants without interruption. The most recent data available indicate that as of June 2003, six states (including New York, Texas, and Illinois) were insolvent in their UI program and had obtained federal loans to continue benefit payments.

Repayment. Federal law specifies how such loans are to be repaid. Federal loans repaid within a federal fiscal year are generally interest free. Federal loans longer than a federal fiscal year will generally be assessed interest charges of 6 percent per annum on the outstanding balance. The principal amount of any funds borrowed will be repaid from the UI fund once the fund is solvent. However, interest charges may not be paid out of the fund and most come from separate state sources. States must demonstrate progress toward restoring solvency to their UI fund within two years of receiving a federal loan, or the federal government may increase the administrative tax (currently 0.8 percent of the taxable wage base) authorized by the Federal Unemployment Tax Act.

Options for Restoring Solvency

In order to return the UI fund to solvency and repay the federal loan, the state essentially has four choices: (1) increase the taxable wage base; (2) increase the rate schedules (3) reduce benefit payments, or (4) some combination of the previous three options. Unemployment insurance benefit levels and tax rates are policy decisions for the Legislature. To assist the Legislature, we compare benefits and taxes in other states and present example packages of reforms that would achieve solvency.

Comparing Average Weekly Benefits. Figure 1 compares the average weekly benefit, the taxable wage base, and the maximum tax rate for the ten largest states. In the fourth quarter of 2003, California's average weekly benefit was $251, seventh among the ten largest states, $19 less than the average for the ten largest states, and about $10 less than the average for the United States. This was the latest available data from the DOL.

Comparing Taxable Wage Bases and Maximum Tax Rates. Figure 1 also shows the taxable wage base for the ten largest states. Only California and Florida have set the taxable wage base at the federal floor of $7,000. Most large states (7 of 10) have set the taxable wage between $8,500 and $9,000. In terms of nearby states, Nevada, Oregon, and Washington all have taxable wage bases above $20,000. Arizona is currently the same as California at $7,000. With respect to the maximum tax rates for employers in 2002, California's rates were among the lowest of the ten largest states.

In summary, California's average UI benefits in 2003 were below the national average and within the lower range of the ten largest states. California's taxable wage base and maximum tax rates are also relatively low. Below we present three options for consideration by the Legislature for addressing the UI fund insolvency. Each of these options assumes January 2005 implementation, is based on EDD's economic forecast, and restores solvency by 2006 (including repayment of the loan principal).

Option 1: Benefit Reduction With No Tax Increase. In order to make the UI fund solvent without increasing the taxable wage base from $7,000, benefits would need to be reduced to $230 (the level in 2001, prior to the benefit increases provided under Chapter 409 and Chapter 4xxx). Specifically, reducing benefits to $230 per week would reduce benefit payments by $1.8 billion in 2005 and $2.3 billion in 2006. The UI fund would achieve a positive balance in 2006, and Schedule F+ would remain in effect.

Option 2: Increase Taxable Wage Base With No Benefit Reduction. To achieve solvency while allowing the maximum weekly benefit to increase from $410 in 2004 to $450 in 2005, would require increasing the taxable wage base from $7,000 to $10,000. This would increase employer contributions by $1.3 billion in 2005 and $1.6 billion in 2006. The average cost to an employer for each employee who reaches $10,000 in taxable wages would be $466, an increase of about $140. Under this scenario, the UI fund would achieve a positive balance in 2006 and Schedule F+ would remain in effect.

Option 3: A Combination of Benefit Reductions With an Increase in the Taxable Wage Base. Under this approach, there could be any number of combinations for addressing the UI fund's insolvency. For example, the maximum weekly benefit could be reduced to $330 in 2005, the maximum wage replacement could be reduced to 45 percent, and the taxable wage base could rise to $9,000. This would increase employer contributions by $0.9 billion in 2005 and $1.1 billion in 2006. The average cost to an employer for each employee who reaches $9,000 in taxable wages would be $420, an increase of about $90. As with the previous options, solvency would be restored in 2006 and Schedule F+ would remain in effect.

Minimal Solutions. All of the above options would minimally restore solvency to the UI fund in 2006, and the projected balances for 2007 and 2008 would be far below prudent reserve levels. Federal guidelines suggest a prudent fund balance would be about $8.2 billion. Another recession could easily send the fund back into insolvency. In developing a solution, the Legislature should consider the long-term outlook for UI benefit payments, the fund condition, and the impact on employers.

What About Mid-Year Changes? The above scenarios assumed no change in benefits or taxes until January 2005. Although mid-year changes in both tax rates and benefits are possible, each poses administrative difficulties. This is especially the case with increasing the taxable wage base. Because most workers earn $7,000 prior to mid-year, employers finish paying their UI taxes for many employees. Accordingly, raising the tax rate mid-year during 2004 would be administratively cumbersome for employer accounting systems as they would need to redetermine which employees need additional tax payments. Alternatively, changing benefits mid-year would involve reprogramming and administrative costs at EDD, but the impact on employers would be minimal.

No Proposal in Governor's Budget

The Governor's budget contains no proposal for addressing the insolvency of the UI fund. The Governor's Budget Summary explains that (1) the administration is working with stakeholders from labor and business in order to develop a consensus on the issue and (2) budgetary impacts of the administration's UI solution will be included in the May Revision. Any interest payment owed to the federal government would require an appropriation, either in the 2004-05 Budget Act or separate legislation.

Legislatively Mandated Report Not Completed. Chapter 1022, Statutes of 2002 (AB 444, Committee on Budget) required EDD to convene a stakeholders group to study alternative funding mechanisms for the UI program. Chapter 1022 required a report to the Legislature by December 31, 2003. At the time this analysis was prepared, the EDD had not submitted the report.

Conclusion

In order to return the UI fund to solvency, the Legislature must reduce UI benefits, increase UI taxes, or do some combination of both. In developing a solution, the Legislature should consider both the short- and long-term impacts on unemployed workers and employers.