Unemployment Insurance as Cooperative Federalism

As part of my effort to blog about something even more boring than tax law (and, admittedly, it was a challenge), I recently started getting interested in unemployment insurance.  And, whaddya know, UI is actually a pretty fascinating example of cooperative federalism.  The administration just put some major reforms of UI on the table, so this seems like a good time to, ahem, bore into the subject.  As an insurance program run at the state level, UI also offers useful lessons for health care reform.  For instance, right now it faces major pressures from accumulating moral hazard and the centrifugal forces of federalism.    

Unless you're a small-business owner or Depression-era historian, you probably have no idea where the money for UI comes from or who sets the rules for the program.   So I'll tell you.  Under the system set up in 1936, and pretty much unchanged in its major details since then, UI  is a complicated tangle of state and federal rules and dollars.  Both states and feds impose taxes on employers to fund their programs: states pay most benefits, but the federal government shares the cost of very long-term unemployment and can lend to states whose funds go broke.  States can set their own rules for eligibility and benefits, subject to some federal standards. 

What was most surprising to me about UI was the degree to which states follow the federal standards despite predictable federalism-related pressure on states to reduce taxes and cut benefits.  Businesses threaten to leave states that raise UI taxes, and high benefits attract those who expect to have trouble holding a job, increasing the costs of UI and other social insurance programs.  What holds the program together?  A draconian federal penalty, which effectively increases  federal taxes on employers by 700% (from .7% to 5.4% of salaries paid) in any state that fails to meet federal standards.  Needless to say, local officials are not eager to face the blowback they'd get from triggering that penalty -- a feature the UI designers explicitly planned as a way of ensuring uniformity without the need to bring enforcement actions directly against states. 

Federal penalties are also what is supposed to reduce moral hazard among states, but the penalties are looking less and less effective every day.  More on that problem, and how the administrataion proposal both worsens and helps it, in the next post.  Can't wait, can you?