Increase Taxes That Finance the Federal Share of the Unemployment Insurance System

CBO periodically issues a compendium of policy options (called Options for Reducing the Deficit) covering a broad range of issues, as well as separate reports that include options for changing federal tax and spending policies in particular areas. This option appears in one of those publications. The options are derived from many sources and reflect a range of possibilities. For each option, CBO presents an estimate of its effects on the budget but makes no recommendations. Inclusion or exclusion of any particular option does not imply an endorsement or rejection by CBO.

(Billions of dollars) 2014 2015 2016 2017 2018 2019 2020 2021 2022 2023 2014-2018 2014-2023
Change in Revenues                        
  Increase the net FUTA rate to 0.8 percent 1.0 1.4 1.4 1.5 1.5 1.5 1.5 1.5 1.5 1.5 6.8 14.4
  Increase the FUTA base to $14,000, index the base to future wage growth, and decrease the net FUTA rate to 0.33 percent 4.9 8.5 2.5 -1.4 -1.5 -2.3 -2.2 1.0 2.1 2.9 13.0 14.5

Notes: This option would take effect in January 2014.

FUTA = Federal Unemployment Tax Act.

The unemployment insurance (UI) system is a partnership between the federal government and state governments that provides a temporary weekly benefit—consisting of a regular benefit and, often during economic downturns, extended and emergency benefits—to qualified workers who lose their job through no fault of their own. Funding for unemployment insurance is drawn from payroll taxes imposed on employers both by state governments and by the federal government.

The states administer the UI system, establishing eligibility rules, setting the regular benefit amounts, and paying out those benefits to eligible people. To finance benefits, states impose payroll taxes on employers. State payroll taxes vary, with each state setting a tax rate schedule and a maximum wage amount subject to tax. Revenues from state payroll taxes are deposited into dedicated state accounts within the federal budget.

The federal government sets broad guidelines for the UI system, pays a portion of the administrative costs that state governments incur, and makes advances to states that lack the money to pay UI benefits. In addition, during periods of high unemployment, the federal government has often funded, either fully or partially, supplemental benefits through the extended benefits program, temporary emergency benefits, or both.

Funding for the federal portion of the unemployment insurance system is drawn from payroll taxes imposed on employers under the Federal Unemployment Tax Act (FUTA). FUTA taxes are levied on each worker’s wages up to $7,000 and then deposited into several federal accounts. That amount is not adjusted, or indexed, for inflation and has remained unchanged since 1983. The FUTA tax rate is 6.0 percent, reduced by a credit of 5.4 percent for state taxes paid, for a net tax rate of 0.6 percent—or $42 for each employee earning at least $7,000 annually. On January 1, 1976, a surtax of 0.2 percent went into effect, raising the total FUTA tax rate, net of the state tax credits, to 0.8 percent—for a maximum of $56 per employee. However, that surtax expired on July 1, 2011.

During and after the last recession, the funds in the federal accounts were insufficient to pay the emergency and extended benefits enacted by the Congress, to pay the higher administrative costs that states incurred because of the greater number of people receiving benefits, and to make advances to several states that did not have sufficient funds to pay regular benefits. That shortfall necessitated that advances be made from the general fund of the U.S. Treasury to the federal accounts. Some of those advances must be repaid, a process that the Congressional Budget Office projects will take several years under current law.

This option includes two alternative approaches that would increase revenues from unemployment insurance taxes by roughly the same amount over the 2014–2023 period. The first approach would leave the FUTA tax base unchanged but would raise the net FUTA tax rate by reinstating and permanently extending the 0.2 percent FUTA surtax. CBO estimates that this approach would generate a steady flow of additional revenues in each year between 2014 and 2023, for a total increase of $14 billion.

The second approach would expand the FUTA tax base but decrease the tax rate. Specifically, the approach would raise the amount of wages subject to the FUTA tax from $7,000 to $14,000 in 2014 (and then index that threshold to the growth in future wages), and it would reduce the net FUTA tax rate, after the 5.4 percent credit for state taxes paid, to 0.33 percent. CBO estimates that this approach would raise revenues by $15 billion over the 2014–2023 period.

The net increase in revenues from the second approach would be attributable to several factors. First, in 2014, the direct revenue gain that would result from expanding the FUTA tax base would roughly offset the revenue losses from lowering the FUTA tax rate; in future years, the growth in the tax base would cause that gain to exceed that loss. Second, revenues from state unemployment insurance taxes, which are counted as part of the federal budget, would rise as well. Because federal law requires that each state’s UI taxes be levied on a taxable wage base that is at least as large as the federal taxable wage base, 27 states would have to increase their taxable wage base to $14,000 under this approach. CBO expects that many states would reduce their UI tax rates in response but would leave those rates high enough to maintain some of the additional revenue. States with low UI account balances would be especially likely to retain some of the additional revenue.

The pattern of additional revenues generated by the second approach would be very irregular. In the initial years, revenues would rise substantially, mostly because expanding the tax base would increase state UI tax revenues. That extra revenue would allow some states to more quickly repay advances made by the federal government. Those repayments, in turn, would make more employers eligible for the full credit for state taxes paid than is the case under current law, causing revenues to fall in the middle years of the budget window. (Employers in states that received advances from the federal government but have yet to repay those funds do not receive the full credit for state taxes paid; in those instances the forgone credit is directed to the state UI account until the advances are repaid.) By the final years of the period, that effect would fade, and revenues would be higher again because of the expanded tax base.

The main advantage of both approaches is that they would improve the financial condition of the federal portion of the UI system. The additional revenue would allow the federal UI accounts to more rapidly repay the outstanding advances from the general fund and would better position those accounts to finance benefits during future recessions. Another argument in support of the second approach is that expanding the tax base would improve the financial condition of state UI tax systems.

Either approach would generally be simpler to implement—especially by employers—than many other proposed changes to the federal tax code. However, expanding the taxable wage base would impose some burden on state governments, requiring them to ensure that their tax bases conformed to the indexed federal tax base.

An argument against both approaches is that employers would generally pass on the additional FUTA taxes to workers in the form of reduced earnings. By reducing workers’ after-tax pay, the tax might induce some people to choose not to enter the workforce. Both approaches would also increase marginal tax rates for some workers by a small amount. (The marginal tax rate is the percentage of an additional dollar of income from labor or capital that is paid in taxes.) On balance, the evidence suggests that increasing marginal tax rates reduces work relative to what would have occurred otherwise. Given the small size of the tax changes in this option, however, the effects on employment would probably be quite small under either approach.

The combination of a single tax rate and low thresholds on the amount of earnings subject to the tax makes the FUTA tax regressive—that is, FUTA taxes measured as a share of earnings decrease as earnings rise. Even so, because workers with lower earnings receive, on average, UI benefits that are a higher fraction of their prior earnings than do workers with higher earnings, those benefits are progressive. If taxes and benefits are considered together, the unemployment insurance system is generally thought to be roughly proportional—neither progressive nor regressive—under current law. Neither approach described in this option would affect UI benefits, and both approaches would raise revenues by nearly the same total amount over the 10-year period. However, the approaches would have different effects on the distribution of tax burdens: Reinstating the surtax would increase FUTA taxes proportionately for all income groups, while expanding the wage base and lowering the FUTA rate would reduce the regressivity of the FUTA tax.