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Monday, February 21, 2011

Did UI Funding Contribute to the Recession?

In response to (cough) overwhelming demand, coverage of the unemployment insurance system will now resume.   The Great Recession has staggered state UI funds; projections are that more than 30 will go broke and have to turn to the federal government for aid.  As I argued last time, it's not clear that in itself is a bad thing.  But it's possible that the system of UI financing needlessly increased the costs to the feds, and maybe even made the recession deeper than it would have been.  The new Obama administration proposal arguably worsens the problem.      

Below the fold: um, we should fix that. 

State incentives both to under-save and also to take too little care with their own economic management derive from the moral hazard created by the federal lending pool.  If you've already forgotten, the way UI works is that both states and feds tax state employers a percentage of the salaries they pay.  States use these monies to fund benefits paid out to unemployed workers, while the feds use their portion, among other things, to make loans to states whose accumulated balances are insufficient to meet demand.  In effect, the state is promised an easy bailout if it fails to save enough to cover unemployment claims.  So why not take bigger risks, knowing that the feds will clean up the mess?  And, once bad events happen, why undertake costly efforts to mitigate the downside?

Typically, the way insurers curb these kinds of moral hazards costs is with co-pays and deductibles.  The UI system has a kind of co-pay system, but it turns out to be incredibly weak.  If states fail to repay their federal loans within 2 years, their businesses can get hit with an additional federal tax of $21 per employee per year.  That's less than 10% of the average tax each employer pays to the feds annually.  And it won't hit until years after the risky behavior -- possibly well after the risk-taking official has left office. 

There is some rough qualititative evidence to suggest that this $21 figure is way too low, and is encouraging growth of  the moral hazard problem.  The penalty has been $21 since 1983.  Over time, as the real value of the penalty has declined, state fund balances have declined, while incidents of state borrowing and states triggering federal penalties have increased.  As I say, this is just qualitative evidence, since obviously to make this point more rigorously we'd want to control for economic conditions and so on.  (Watch this space next year for reports on how that turns out...) But I think what we have is pretty suggestive.

So, step one to reforming UI insurance is to raise the penalty, and to index it.  The administration's proposal (accidentally?) increases the penalty amount, by increasing the federal "taxable amount" that all federal taxes, including the penalty, are based on.  But it doesn't index that amount, which based on what I've just said seems like a mistake.  

Another problem is that the proposal on the table would extend the period for state repayments without penalty, which again is a form of bailout.  If we're going to do things that increase the likelihood of moral hazard, we should also put in place reforms that would tend to counteract it.

Posted by BDG on February 21, 2011 at 01:41 PM in Tax | Permalink

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