California's Other Budget Deficit: The Unemployment Insurance Fund Insolvency

California’s Other Budget Deficit: The Unemployment Insurance Fund Insolvency M AC TAylor • l e g i s l A T i v e A n A l y s T • oCTober 20, 2010 an LaO RepORt 2 LegisLative anaLyst’s Office an LaO RepORt ExEcutivE Summary Background. The Unemployment Insurance (UI) program provides weekly UI payments to eligible workers who lose their jobs through no fault of their own. The program is financed by unemployment tax contributions paid by employers. The UI Fund Is Currently Insolvent. The UI fund became insolvent in January 2009 and ended that year with a shortfall of $6.2 billion. Absent corrective action, the fund deficit is projected to increase to approximately $20 billion at the end of 2011 (Employment Development Department [EDD] will soon update these projections). During 2009, the state paid about $11.3 billion in benefits to workers while collecting only about $4.5 billion from employers. This recent spike in benefit costs is due to the recession, which resulted in more workers than ever applying for UI benefits. Federal Loan Supports Benefit Payments With Interest Costs to the State. Since January 2009, EDD has been obtaining quarterly loans from the federal government to cover the UI fund deficit. These federal loans have permitted California to make payments to UI claimants without interruption. Generally, loans lasting more than one year require interest payments. The federal American Recovery and Reinvestment Act (ARRA) of 2009 provides temporary relief to states from making interest payments on UI loans through December 31, 2010. With the expira- tion of these ARRA provisions, EDD estimated in May 2010 that California could owe about $500 million in September 2011 and would face growing interest obligations in the out years. Difficult Choices for the Legislature. The Legislature essentially has three main choices for returning the UI fund to solvency: (1) reducing benefit payments, (2) increasing employer tax contributions, or (3) adopting some combination of the previous two options. To assist the Leg- islature we examined multiple scenarios for achieving solvency and found that: ➢ Decreasing UI benefits alone cannot address the fund insolvency in the near future. ➢ Options involving UI tax increases could quickly improve the fund condition. ➢ Employer tax increases could hurt California’s competitiveness. ➢ The UI financing structure is not sufficiently robust. Strategies for Achieving Solvency. In developing a strategy to bring solvency to the UI fund, we recommend that the Legislature: ➢ Attempt to minimize adverse impacts on the economy. ➢ Make both tax and benefit changes. ➢ Consider different approaches for the short term (2011 and 2012) than for the long term. ➢ At a minimum, take prompt action to bring UI benefits and tax revenues into line so that the accumulated deficit and associated interest obligation stops growing. LegisLative anaLyst’s Office 3 an LaO RepORt 4 LegisLative anaLyst’s Office an LaO RepORt IntroductIon The state’s UI fund is currently insolvent and, In our January 2009 report, 2009‑10 Budget absent corrective action, will remain so for the Analysis Series—General Government, we pro- foreseeable future. During the November 2008 vided an overview of the UI program, described special session, the Governor introduced a pro- the deterioration of the UI fund, and provided posal, which has not yet been acted upon by the our initial thoughts on the administration’s Legislature, to restore solvency to the UI fund. In proposal to restore solvency. The purpose of addition, two bills—SB 222 (Ducheny) and this report is to provide an update on the status AB 1298 (Coto)—were introduced in Febru- of the UI fund, compare California’s UI tax and ary 2009 to address the insolvency. However, benefit measures to other states, review options neither bill moved out of its respective policy for restoring fund solvency, and analyze various committees. scenarios to provide the Legislature with some context as it considers potential solutions to ad- dress the UI fund deficit. Background Overview combination of federal and state unemployment taxes of up to $490 per covered employee per The UI program is a federal-state program, year. The majority of these employer taxes are authorized in federal law but with broad discre- used to fund benefit payments. A smaller portion tion for states to set benefit and employer contri- of the taxes goes to the federal government to bution levels. The UI program provides weekly pay for administration. We describe the Cali- UI payments to eligible workers who lose their fornia UI program’s financing structure in more jobs through no fault of their own. The program detail below. is financed by unemployment tax contributions Taxable Wage Base. California employers paid by employers for each covered worker. pay unemployment taxes on the first $7,000 in Regular UI benefits are generally paid for a annual wages paid to employees. Federal law maximum of 26 weeks. However, during periods requires states to have a minimum taxable wage of high unemployment, some state and federally base of $7,000. Currently, California and four funded extended benefits may be available to other states have a taxable wage base at this workers who have exhausted regular UI benefits. federal minimum. California’s UI program is administered by EDD. Federal Tax Rate. The federal portion of California’s UI Financing Structure unemployment taxes is used to fund program administration. The effective federal tax rate for The current average weekly benefit is about administration is 0.8 percent as long as a state’s $300 per week and paid for an average of UI program is in compliance with federal re- 20 weeks. To pay for the cost of providing UI quirements. benefits, California employers currently pay a LegisLative anaLyst’s Office 5 an LaO RepORt State Tax Rates. The state portion of unem- ratios pay the lowest taxes while firms with nega- ployment taxes funds benefit payments. Current tive ratios pay the highest taxes. Although actual state law establishes a series of contribution taxes paid correspond to a firm’s specific reserve rate schedules ranging from AA to F (schedule ratio, certain industries tend to have positive ra- AA has the lowest employer contribution rates, tios (like retail trade), while other industries tend with the remaining schedules increasing from A to have negative reserve ratios. Figure 1 shows to F). Each rate schedule varies in accordance the range of average tax rates by industry. (We with the condition of the UI fund. Schedule AA note that positive reserve firms subsidize nega- is used when the fund condition is the healthi- tive reserve firms and the cross subsidization is est and schedule F (with the highest contribution sometimes called “socialization.”) rates) is used when the fund condition is weak California’s UI Benefit Provisions (approaching a deficit). Current law also autho- rizes schedule “F+,” which includes a 15 percent Statutory Benefit Level. State law establishes solvency surcharge above the rates established the benefit levels to be paid to unemployed in schedule F, for use when the fund is under ex- workers. The current UI weekly benefit in Cali- treme distress, as it is now. Based on the UI fund fornia ranges from a minimum of $40 to a maxi- condition, the F+ schedule is currently in place. mum of $450. The amount of benefits available Current state tax rates range from 0.1 percent is based on the claimant’s earnings in the “base (the lowest rate on Schedule AA) to 6.2 percent period,” which is 12 months. (Please see the box (the maximum rate on Schedule F+). on page 8 for more information on the base pe- What an employer contributes to support riod and how it is calculated.) The quarter within the UI system also is affected by the record of the base period in which the highest wages were an employer’s former employees in claiming UI received generally is the basis for determining benefits. This is known as an “experience rat- the weekly benefit amount. Figure 2 provides ing.” The EDD keeps a separate account for each examples of various UI benefit amounts based business in California, recording tax payments Figure 1 into the system and State UI Tax Burdens Vary Across Industries benefit payments to the Average 2009 Tax Rates on the F+ Schedule firm’s former employees. Industry Tax Rate Firms that pay more in Retail trade 3.6% taxes than is paid out to Transportation and public utilities 4.5 their laid off employees Wholesale trade 4.7 Public administration 4.7 have a positive reserve Services 5.2 ratio. When benefits paid Manufacturing 5.4 out exceed a firm’s tax Finance, insurance, real estate 5.4 Mining 5.9 payments, the firm has Other 5.9 a negative reserve ratio. Agriculture, forestry, fishing 6.2 Firms with high positive Construction 6.2 6 LegisLative anaLyst’s Office an LaO RepORt on earned wages. For 2009, the average benefit In terms of nonmonetary requirements, payment was $299 per week. claimants must be out of work through no fault The primary goal of the UI program is to of their own. In addition, claimants must be provide partial replacement of wages for indi- able to work, be seeking work, and be willing to viduals who involuntarily experience job loss. accept a suitable job if offered one. As part of California’s wage replacement rate for the UI the eligibility process, claimants must show that program—which is set in statute—is 50 percent, they are looking for work and are meeting these subject to the maximum amount of $450 per requirements. If a claimant is not in compliance week. As previously mentioned, most states, with these nonmonetary requirements, overpay- including California, provide regular UI benefits ment notices and penalty assessments may be for a maximum of 26 weeks. applied. Legislative Changes to Benefit Provisions. Figure 2 From 1992 through 2001, the maximum weekly Examples of How UI Benefit Amounts benefit amount for UI was $230, paid for Vary With Prior Wages 26 weeks. The wage replacement rate was also Amount of Wages in Weekly Benefit limited to 39 percent, subject to the cap of Highest Quarter Amount $230 per week. Chapter 409, Statutes of 2001 $900.00–$948.99 $40 (SB 40, Alarcón), provided for a total increase 3,822.01–3,848.00 148 in the maximum weekly benefit of $220 phased 7,956.01–7,982.00 307 11,674.01 and over 450 in over a four-year period. Chapter 409 also increased wage replacement from 39 percent to 45 percent effective January 2002, and to 50 per- Eligibility Provisions. Eligibility for the UI cent effective January 2003. Since Chapter 409 program depends upon both monetary and non- was implemented, there have not been addition- monetary requirements. In terms of monetary al changes to the state’s UI benefit provisions. requirements, a claimant must have generally We note that although Chapter 409 nearly earned (1) at least $900 in a single quarter, as doubled the maximum UI weekly benefit well as $1,125 total in the 12-month base period amount from $230 to $450 over a phased-in or (2) at least $1,300 in any quarter in the base period, the legislation did not raise the taxable period to qualify for UI benefits in California. wage base of $7,000 per worker nor did it in- These eligibility requirements have been in place crease the tax rate schedules. since 1992 and have not been adjusted since that time for changes in average wages. LegisLative anaLyst’s Office 7 an LaO RepORt Federal Incentive Opportunity for Base Period Modification All states use a base period to determine whether potential claimants have earned enough wages to qualify for unemployment insurance (UI) benefits. A base period is typically four calendar quarters, and most states, including California, traditionally define their base period as the first four of the last five completed quarters at the time a UI claim is filed. This means that, when using a traditional base period, the last few months of wages earned by a potential claimant cannot be counted in determining UI benefit eligibility. Alternative Base Period Expands Coverage. In the past few years, some states have adopted alter- native base periods (ABP) to allow more unemployed individuals to qualify for UI benefits. The ABP typically shifts the 12-month base period to count wages earned in the calendar quarter in which the claimant files for UI or the most recent prior completed quarter. The ABP generally allows claimants to qualify for UI benefits sooner than under a traditional base period, which will tend to benefit part-time or low-wage earners, seasonal workers, and recent entrants to the workforce. Federal Incentive Payment Available for Expanded UI Coverage. The federal American Recovery and Reinvestment Act (ARRA) of 2009 appropriated $7 billion for states to expand their UI cover- age, including through the adoption of ABPs. The additional funding may be used by states to make UI benefit payments, or to fund improvements to the UI program. The incentive payments will be provided to states in two separate lump sums—(1) the first one-third of the incentive payment will be provided to a state once it authorizes the use of an ABP in determining UI eligibility and (2) the remain- ing two-thirds of the incentive payment will be provided once the ABP is implemented and the state meets two of four additional expanded coverage requirements. The ARRA also included $500 million for state grants, intended to assist states in upgrading their information technology systems and/or the administration of the program. California to Implement ABP. Because the state’s UI program meets the federal requirements, California only needs to implement an ABP in order to qualify for the entire incentive payment, esti- mated to be about $840 million. In March 2009, the Legislature and Governor enacted Chapter 23, Statutes of 2009 (AB 3 29, Coto and Garrick), to create an ABP for California’s UI program by April 2011. (We note that the Legislature has recently extended this deadline due to various implementation issues.) Chapter 23 provides that if a potential claimant does not qualify for UI benefits using the tradi- tional base period, an ABP that includes the most recently completed calendar quarter may be used to determine UI eligibility. Incentive Payment Must Fund Benefit Payments. The Employment Development Department (EDD) is using a portion of California’s ARRA UI administration grant of about $60 million to make the technical changes necessary to implement ABP. The EDD estimates that the additional benefit payment costs resulting from expanding UI coverage through ABP implementation will be about $70 million per year (although this amount will fluctuate over time). This means that the incentive payment could cover around ten years of additional UI payments related to ABP. We note that because the UI fund is cur- rently insolvent, the state will have less discretion in how it uses the incentive payment. 8 LegisLative anaLyst’s Office an LaO RepORt thE ui Fund iS currEntly inSolvEnt The UI fund became insolvent in January actual and projected UI fund conditions discussed 2009 and ended that year with a shortfall of in this report tie to EDD’s May 2010 forecast. The $6.2 billion. Absent corrective action, the fund EDD updates their forecast semiannually—in late deficit is projected to increase to $15.3 billion May and October of each year. Future changes in at the end of 2010 and $20.9 billion at the end EDD forecasts are unlikely to alter our findings in of 2011. These EDD deficit estimates assume a significant way.) California unemployment rates of 12 percent for Evolution of the UI Fund Condition 2010 and 11 percent for 2011, which we believe are reasonable projections. As shown in Figure 3, One of the contributing factors to the current EDD forecasted in May 2010 that benefits paid UI fund insolvency problem was the inability of from the state UI fund will total $11 billion in the fund to build a healthy reserve in the last de- 2009, $14 billion in 2010, and $11 billion in 2011. cade. Below, we describe the changing conditions Employer contributions, however, are much lower, that have impacted the UI fund over the years. totaling $4.2 billion in 2009, $4.4 billion in 2010, History of the UI Fund Condition. As Fig- and $4.9 billion in 2011. We note that California ure 4 shows, California’s UI financing structure is not alone in experiencing a UI fund deficit, as worked well up until recent years. The fund about 30 other states are in deficit situations. (The balance built sufficient reserves during times of economic expansion so that the lowest tax rate Figure 3 schedule could be used UI Fund Facing Severe Deficit before entering a period (In Billions) of economic contrac- $20 tion. This pattern ended 15 in the 1990s. In the Benefits 10 years leading up to the Contributions recession of the early 5 2000s, the fund was 0 unable to build a high Fund Balance -5 enough reserve to safely cover the next recession. -10 Employers were still on -15 schedule C in the late 1990s and in the early -20 2000s, as the state en- -25 tered into a brief reces- 2006 2007 2008 2009 2010 2011 sion. Soon after, benefits Source: EDD May 2010 Forecast. LegisLative anaLyst’s Office 9 an LaO RepORt levels were increased with no changes to the Federal Loan Means No Interruption revenue structure. As shown in Figure 4, the fund In Benefits balance dipped below $1 billion in 2004. As the Federal Loan. Since January 2009, EDD has state entered this most recent recession in 2008, been obtaining quarterly loans that are available in which the unemployment rate hit record highs, from the federal government to cover the UI fund the fund had an insufficient reserve, even though deficit. These federal loans have permitted Cali- employers had been on the highest state tax rate fornia to make payments to UI claimants without schedule—F+—since 2004. The EDD estimates interruption. As of September 2010, the state’s that even as more firms pay higher rates under outstanding federal loan for benefit payments the F+ schedule, the current system can only was approximately $8 billion. generate about $6 billion in annual revenues. Repayment. Federal loans to state UI funds The situation in the late 1990s and early that are repaid within a federal fiscal year are 2000s suggests that the UI financing system was generally interest free. However, federal loans not robust enough to build sufficient reserves. that carry over from one federal fiscal year to the According to EDD estimates, the existing UI next will generally be assessed interest pursuant financing system can be sustained in the long to a federal formula. Currently, the interest rate is run only if the state unemployment rate aver- about 5 percent per year on the outstanding bal- aged around 4 percent over time. Such low Figure 4 rates of unemployment Funding Structure Unable to Address Impact have been historically Of Recession rare in California. Given UI Fund Balance (In Billions) that the state’s current $8 unemployment rate tops 12 percent and 6 AA C is expected to remain 4 Low D fairly high for the next E F+ 2 several years, the High F+ Legislature will need to 0 reform California’s UI -2 system to achieve and Recession Period maintain the solvency of -4 the UI fund. We discuss -6 specific approaches to F+ modifying the UI financ- -8 ing structure later in this -10 report. 1975 1980 1985 1990 1995 2000 2005 Letters on selected years refer to the UI tax rate schedule, ranging from when the UI Fund condition is in the best condition (AA, or “Low” prior to 1985) to the worst (F+, or “High” prior to 1984). 10 LegisLative anaLyst’s Office an LaO RepORt ance. Interest charges may not be paid out of the include (1) making progress toward addressing fund and must be paid separately by states from the underlying problem that resulted in the bor- another fund source—in California’s case, most rowing of federal funds for California’s UI system likely the General Fund. The principal amount and (2) making timely payments of the interest of any funds borrowed is not due immediately, owed on the federal loan. As described below, but must be repaid automatically to the federal failing to meet these conditions could result in government from the UI fund whenever it has a increased costs for employers and the state. positive balance. Condition 1: Addressing the Underlying Interest Temporarily Waived. The ARRA Problem. Employers would face serious long- includes several provisions impacting the UI term consequences if the state fails to address program, which we outlined in our March 2009 the underlying problem that resulted in this report, 2009‑10 Budget Analysis Series—Federal borrowing of federal funds for the UI system. Economic Stimulus Package: Fiscal Effect on Cali‑ Federal law includes provisions to ensure that a fornia. In particular, ARRA provides temporary state does not continue to incur loans over an relief to states from making interest payments on extended period. Specifically, if a state has an federal UI loans through December 31, 2010. outstanding loan balance on January 1 for two Interest does not accrue on the principal amount consecutive years, the full amount of the loan borrowed during this forgiveness period. The must be repaid before November of the second EDD estimated that these provisions would save year or employers would face higher federal UI California a few hundred million in interest costs taxes. (The current 0.8 percent federal tax would in 2009 and 2010. increase each year in increments—starting with When these ARRA provisions expire, the state an increase of 0.3 percentage points—until the must start making these interest payments. In May loan was repaid.) Once the fund reached sol- 2010, the EDD estimated that, absent any correc- vency, the annual federal UI tax rate would once tive action, the state would owe about $500 mil- again drop to 0.8 percent. As shown in Figure 5, lion in the fall of 2011. Absent an alternative employers could face their first tax increase as financing solution, the payment of this interest early as 2012, which would result in an increased cost will likely come from the General Fund. Figure 5 Potential Consequences of Fund Federal UI Tax Increases if Fund Insolvency Are Significant Continues to Be Insolvent The current UI fund insolvency has signifi- Aggregate Increase cant potential consequences. Specifically, the Annual Federal UI in Employer Cost Year Tax Per Employee (In Millions) state must meet several conditions in order to (1) obtain the federal loans which support the un- 2011 $56 — 2012 77 $325 interrupted payment of UI benefits and (2) main- 2013 98 650 tain the federal tax rate at 0.8 percent. (This fed- 2014 119 975 eral tax rate can increase to as much as 6.2 per- 2015 140 1,300 2016 196 2,167 cent absent state compliance.) These conditions LegisLative anaLyst’s Office 11 an LaO RepORt annual cost of about $325 million to employers. reflect crediting the federal tax increases shown Absent corrective action, the federal tax would in Figure 5.) continue to increase incrementally each year to Condition 2: Making Interest Payments a maximum of 6.2 percent, resulting in increased on Time. If the state fails to make interest pay- employer costs of approximately $6 billion ments on time, employers would immediately annually. We note that even this $6 billion tax face the $6 billion in costs that might otherwise increase would not be enough, at this point, to be phased in gradually as described above. address the insolvency problem and cover the The state would also lose its entire federal UI projected fund deficit. These additional federal administrative grant, which is typically around administrative taxes are applied to the principal $400 million annually, until the interest has been balance of the state’s federal UI loan. (Refer- paid. Absent these federal funds, UI administra- ences in this report to the state’s UI deficit do not tive costs would most likely be backfilled by the General Fund. EarliEr ProPoSalS to addrESS inSolvEncy As previously noted, the Governor intro- ➢ Reducing the wage replacement rate duced a proposal in November 2008 to address from 50 percent to 45 percent for certain the UI fund insolvency. In addition to the Gover- employees. nor’s proposal, two bills were introduced in the ➢ Tightening eligibility by increasing the spring of 2009 to address the problem. Below, amount a claimant must generally earn in we briefly describe the key features of these the highest wage quarter in a 12-month proposals. base period to qualify for benefits from Key Features of the Governor’s Proposal $1,300 to $3,200. To address the UI fund insolvency, the Gov- ➢ Increasing the penalty assessments im- ernor’s proposal included several changes, which posed on individuals disqualified from UI would have commenced on January 1, 2010, benefits for quitting work without good to both the revenue and benefit sides of the UI cause or being terminated from work program. with good cause. The key features of the Governor’s proposal Figure 6 details the estimated impact of the Gov- were: ernor’s proposal on employers and UI claimants. ➢ Increasing the taxable wage base from $7,000 to $10,500 per employee. Legislative Proposals to Address UI Problem ➢ Increasing the tax rates on each of the tax schedules, which would increase the Senate Bill 222, which was introduced in maximum state tax rate from 6.2 percent February 2009, proposed to increase the taxable to 8.1 percent. wage base from $7,000 to $21,000. Assembly 12 LegisLative anaLyst’s Office an LaO RepORt Bill 1298, which was also introduced in February indexing the taxable wage base to the average 2009, proposed several changes to the UI pro- annual wages of employees and increasing tax gram beginning in 2011, including increasing and rates. These bills were not enacted into law. comParing caliFornia’S ui taxES and BEnEFitS to othEr StatES As the Legislature considers the best ap- some of which are described in more detail proach to addressing the UI program deficit, it below. In summary, while California’s UI benefits may be helpful to consider how California’s UI are near the average for the ten largest states and program compares to those of other states. The the national average, the average employer cost EDD commissioned such a review in the summer in California for the UI program is substantially of 2009, and the resulting study—California’s higher than the average cost for the ten largest Unemployment Insurance System and Financing states and the national average cost. We believe Study Parameters—was released in August 2009. this is because (1) California provides UI benefits Based on data from that report, as well as our to more claimants as compared to other states, own review and analysis of U.S. Department of and (2) the average duration of benefits in Cali- Labor data, we have compared several measures fornia is longer than other states, as we discuss of UI benefits and taxes under current law with later in the report. those of the ten largest states in population and Comparing Benefits the national average. Figures 7 and 8 (see next page) include several key UI program measures, Weekly Benefit Amounts. As shown in Fig- ure 7, California’s average weekly benefit amount Figure 6 for calendar year 2008— Impact of the Governor’s November 2008 Proposed $307—was a little higher Changes to the UI Program than that of other large Examples of Estimated Effect on states. Specifically, this Proposed Policy Change Employer Impact Workers amount was tied for third Increasing the taxable Median tax increase of $230 — wage base from $7,000 to per employee per year. highest among the ten $10,500 per employee. largest states, and was Increasing the tax rates on Median tax increase of $123 — $10 more than both the each tax schedule (on per employee per year. $10,500 base). average for the ten larg- Reducing the wage replace- — 396,000 ( 26% of est states and the nation- ment rate from 50 percent claimants) would al average. The state’s to 45 percent. have decreased benefits. maximum weekly benefit Increasing the minimum — 29,700 (2% of amount of $450 was the eligibility to qualify for claimants) would benefits. lose benefits. fourth highest among the LegisLative anaLyst’s Office 13 an LaO RepORt ten largest states. It was $18 more than the aver- nor’s 2008 proposal would have brought the age for the ten largest states and $30 more than maximum state tax charged per employee per the national average. year to about $851—considerably closer to the Wage Replacement. Because California is national average. A more important measure to considered a high-wage and high-cost state, our consider, however, is the average (rather than analysis also considered how UI benefits com- the maximum) contributions by employers per pare with those of other states in replacing the employee. By this measure, California employers wages lost by recipients. California’s average bear a relatively heavy UI tax burden. As shown weekly benefit covered about 31 percent of aver- in Figure 8, the estimated average annual UI age weekly wages in 2008. This average wage contribution per covered employee in 2008 was replacement rate was below the average rate for $363. This contribution level is the fourth highest the ten largest states and the national average, among the ten largest states. This was $66 more which were both 35 percent. Therefore, although than the average for the ten largest states, and California’s actual weekly benefit amount was $82 more than the national average. above average in 2008, the benefit amount cov- Employer Costs Compared to Wages. Cali- ered a lesser share of workers’ average wages. fornia’s average annual effective UI tax rate for Duration of Benefits. As previously men- employers (computed as the total UI contribu- tioned, California and most other states provide tions collectively paid by employers divided by regular UI benefits for a maximum of 26 weeks. the total wages for the year) was 0.70 percent In 2008, the average duration of benefits in Cali- in 2008. This was slightly higher than both the fornia was 16.6 weeks, while both the average average tax rate in that year for the ten largest for the ten largest states and the national average states (0.64 percent) and the national average was 14.9 weeks. (0.60 percent). This means that even when tak- ing California’s higher wages into account, our Comparing Employer Contributions employers are, on average, paying a little more in Taxes Paid Per Employee. In our January UI taxes per dollar of wages when compared to 2009 analysis of the UI deficit, we considered other states. how California’s current maximum state tax Comparing Taxable Wage Bases. As previ- per employee ($434 per year) compared to the ously discussed, California’s taxable wage base national average ($995 per year). The Gover- of $7,000 per employee per year for UI taxes is Figure 7 California’s UI Benefits Near Average of Other Large States Average for the Ten Measure California Largest States U.S. Average Average weekly benefit amount $307 $297 $297 Maximum weekly benefit amount 450 432 420 Average wage replacement rate 31% 35% 35% Average duration of benefits (in weeks) 16.6 14.9 14.9 14 LegisLative anaLyst’s Office an LaO RepORt Figure 8 Data Provide a Mixed Picture of How California UI Tax Rates Compare Average for the Ten Measure California Largest States U.S. Average Average annual employer contribution per covered $363 $297 $281 employee Maximum annual employer contribution per covered 434 724 995 employee Average employer contribution as a percentage of 84% 41% 28% maximum contribution Average effective UI tax rate on employers 0.70 0.64 0.60 Taxable wage base $7,000 $9,760 $14,321 Maximum tax rate 6.20% 7.52% 7.50% the minimum federal requirement. This is much Comparing Maximum State Tax Rates. As lower than the average taxable wage base in previously described, California’s current maxi- 2008 for the ten largest states ($9,760) and the mum state tax rate for UI—which includes the national average ($14,321). We note that several solvency surcharge—is 6.2 percent. This rate was states index their taxable wage base to their lower than the 2008 average for the ten larg- average wage, rather than having a static taxable est states and the national average, which was wage base. around 7.5 percent for both. EarliEr ProPoSalS to addrESS ui ShortFall now inSuFFiciEnt to rEStorE SolvEncy As previously described, absent corrective Given the magnitude of the fund deficit, action, the UI fund will remain insolvent for the below we examine how the earlier proposals to foreseeable future. This means that the state will address the UI fund insolvency would affect UI bear significant interest costs—from continuing benefits and taxes and the fiscal condition of the to borrow federal funds to make UI benefit pay- program. Our updated analysis indicates that the ments—in the out years. Employers will face auto- fiscal situation has deteriorated so badly that the matic, incremental increases in their federal UI tax, Governor’s November 2008 proposal is not suf- rising from $56 per employee per year to $196 by ficient to restore solvency to the system. 2016, and continuing to increase in the out years. Updated Analysis of the Figure 9 (see next page) details EDD’s May 2010 Governor’s Proposal estimates of the out-year financial impacts of the UI fund condition under current law on the state At the time the proposal was introduced, the and employers. As noted earlier, the fund balances administration estimated that its proposed chang- do not include the impact of any increases in the es to the UI program would (1) increase employ- federal tax rate that could trigger on in the future. er contributions by approximately $4.1 billion in LegisLative anaLyst’s Office 15 an LaO RepORt 2010 and (2) decrease benefit payments by about employer contribution per employee would $300 million annually. Figure 10 outlines the ma- increase to around $800 per year through 2016. jor revenue and benefit policy changes and their This would be a 120 percent increase over the initial estimated impacts on the UI fund. The average UI tax contribution employers paid per Governor proposed that these changes become employee in 2008, which was $363. The average effective January 2010. tax rate on total wages would increase to about Governor’s Proposal Not Sufficient to 1.4 percent in the years immediately following Restore Solvency. The magnitude of the UI fund implementation of the proposal, compared to insolvency has grown to such a degree that even the average tax rate of 0.70 percent in 2008. This the Governor’s existing proposal is not enough to new average tax rate would be more than double address the fund insolvency in the foreseeable fu- the average rate from 2008 for the ten largest ture. Since the fall of 2008 when the Governor first states (0.64 percent) and the national average proposed his solution, the economy has performed rate (0.60 percent). (We would point out that worse than expected with higher sustained levels these are point-in-time estimates. These mea- of unemployment than contemplated in late 2008. sures of employer costs reflect near-maximum Moreover, the proposal was not implemented for contribution levels due to the current poor health calendar year 2010 as the Governor proposed. For of the UI fund, and would gradually decline as these reasons, the UI deficit was about $6 billion the fund condition improved.) at the end of 2009 and was forecasted to reach Earlier Legislative Proposals Insufficient $15.3 billion by the end of 2010. If the Governor’s 2008 plan were put in place effective January 1, As with the Governor’s proposal, adoption of 2011, it would roughly bring benefit payments and the earlier legislative proposals (SB 222 and revenues into alignment, holding the projected AB 1298) would not fully address the UI insol- deficit at current levels. vency. The deficit is now significantly larger than If the Governor’s proposal was implement- had been projected when this legislation was ed (beginning in 2011), the estimated average introduced. Figure 9 Estimated Impacts of the UI Fund Condition Under Current Law (In Billions) State Interest Aggregate Increase in Employer Federal UI Tax Per Year Fund Balance Cost Cost for Federal Administration Employee 2010 -$15.3 — — $56 2011 -20.9 $0.5 — 56 2012 -25.7 0.9 $0.3 77 2013 -30.0 1.1 0.7 98 2014 -34.4 1.3 1.0 119 2015 -39.0 1.5 1.3 140 2016 -43.7 1.7 2.2 196 16 LegisLative anaLyst’s Office an LaO RepORt ui inSolvEncy rEquirES StrongEr Solution Given the magnitude of the UI fund insol- with data provided by EDD, are for illustrative vency, we believe the Legislature must go beyond purposes only, to provide the Legislature with earlier administration and legislative proposals to some context as it weighs various approaches to achieve and maintain long-term solvency for the address this problem. system. The Legislature essentially has three main We also note that the scenarios utilized the choices for returning the UI fund to solvency: specific economic outlook information avail- (1) reducing benefit payments, (2) increasing the able at a particular point in time. Also, all of the taxable wage base and/or tax rate schedules, or scenarios are highly sensitive to changes in the (3) adopting some combination of the previous unemployment rate. This is because an increase two options. or decrease in the unemployment rate impacts In order to help the Legislature understand both the total benefit amount paid and total con- the magnitude of the benefit and revenue tributions by employers, which in turn impacts changes that would be needed to fully address the fund balance. the problem, we explored various alternative Scenario Descriptions scenarios to achieve fund solvency. To test the sensitivity of changes to UI taxes and benefits Decreasing UI Benefits Alone. There are a on the fund condition, our scenarios show the number of different ways the UI benefit struc- impact of attempting to achieve solvency under ture could be changed to decrease total benefit each of the three main approaches described payments. For example, the Legislature could above. We acknowledge that there are actually decrease the maximum weekly benefit amount, a myriad of different specific types of changes to decrease the wage replacement rate, change the the UI tax and benefit provisions that could be monetary and nonmonetary eligibility require- made to address the fund insolvency. The sce- ments to qualify for UI benefits, or adopt some narios described below, which were developed combination of these options. To assess the impact of changing UI Figure 10 benefit provisions on the Governor’s Proposed Changes to the UI Program fund condition, our sce- nario tested (1) decreasing (In Millions) the wage replacement Annual Fund Proposed Policy Change Benefita rate from 50 percent to 45 percent, (2) increas- Increasing the taxable wage base from $7,000 to $10,500 per $2,700 employee ing the minimum amount Increasing the tax rates on each tax schedule 1,400 a claimant must earn to Reducing the wage replacement rate from 50 percent to 200 45 percent qualify for benefits to the Increasing the minimum eligibility to qualify for benefits 92 level proposed by the Total Solution Value $4,392 Governor in November a Reflects the impact estimated at the time the proposal was introduced in November 2008. 2008, and (3) decreasing LegisLative anaLyst’s Office 17 an LaO RepORt the maximum weekly benefit amount to $230, Impact on the UI Fund which, as described earlier in this report, was Below, we summarize the impact of the last set at this level in 2001. (We tried to test various scenarios we tested on the UI fund deeper reductions but the department of Labor condition, including changes in the outflow of model used by EDD was not designed to analyze total benefits paid and the inflow of UI revenue. extreme benefit decreases.) Figure 11 summarizes the impact of the various Increasing UI Taxes Alone. The Legislature scenarios on the UI fund balance. also has the option of increasing the taxable Our analysis suggests that the benefit reduc- wage base, increasing the tax rates to address tions scenario would not achieve solvency in the UI fund deficit, or taking both actions. To this decade. As Figure 11 indicates, the UI fund assess the financial impact of addressing the would continue to face significant shortfalls fund condition only through these options, our through at least 2016 (the last year for which scenarios tested the effect of increasing tax rates projections are available). Increasing UI taxes to a maximum rate of 10.3 percent (which was alone to the level in our scenario would quickly the highest tax rate among the ten largest states improve the condition of the UI fund, as shown in 2008) and adjusting the taxable wage base to in Figure 11. It would become solvent within two $19,000 (which was about the 70th percentile for years, by the end of 2012, and would achieve a all states) to achieve fund solvency quickly. fund balance of $15 billion by 2016. Finally, the Combining UI Benefit Changes With Tax last scenario, in which we combined UI ben- Changes. We also looked at a scenario in which efit changes with tax changes, results in a more both benefit and tax changes were made to the gradual solution that would likely make the UI UI system. This specific scenario tested a com- fund solvent in 2016. bination of (1) the tax increases proposed by the Governor in November 2008; (2) decreasing the wage replacement rate from 50 percent to 45 percent; (3) decreas- Figure 11 ing the maximum weekly How Different Program Scenarios benefit amount from $450 Affect Year-End Fund Balances to $338, which amounts to a 25 percent decrease; (In Billions) and (4) increasing the Scenarios minimum monetary eli- Combination gibility level to qualify for Current Benefit Tax of Benefit and Year Law Decreases Alone Increases Alone Tax Changes UI benefits from $1,125 in earnings in 12 months to 2011 -$20.9 -$14.1 -$5.1 -$12.1 2012 -25.7 -12.7 5.0 -8.8 $3,680 (which amounts to 2013 -30.0 -10.8 9.4 -5.7 about 11.5 weeks of work 2014 -34.5 -8.7 11.1 -2.8 at the current minimum 2015 -39.0 -6.5 13.0 -0.2 2016 -43.7 -4.3 15.1 2.6 wage). 18 LegisLative anaLyst’s Office an LaO RepORt Impact on the State interest costs are avoided beginning in 2013. As previously noted, the federal government has As previously described, the state would face waived these interest costs for 2009 and 2010. significant ongoing interest costs from continu- ing to borrow federal funds to make UI benefit Impact on UI Claimants payments when the fund is insolvent. Because Addressing the UI insolvency through em- the scenarios we analyzed result in various levels ployer taxes alone would not directly affect of solvency, Figure 12 summarizes the impact on persons claiming their benefits. However, the the state’s borrowing costs. As shown in the fig- scenarios involving proposals to address the ure, the state’s interest costs decrease, compared problem through benefit changes alone, or a to current law, in all scenarios. In the example in combination of tax and benefit changes, would which UI taxes are increased alone to achieve (1) mean some workers would no longer be eli- fund solvency by the end of 2012, future state gible for UI benefits and (2) reduce the amount Figure 12 of benefits paid to those How Different Program Scenarios who still qualified for Affect State Federal Borrowing Costs them. (In Millions) Under our scenario Scenarios which decreases ben- Combination efits alone, an estimated Current Benefit Tax of Benefit and Year Law Decreases Alone Increases Alone Tax Changes 30,000 claimants (about 2 percent of the 2009 2011 $554 $439 $343 $417 2012 947 580 133 468 total) would no longer 2013 1,143 511 — 323 qualify for UI benefits. 2014 1,331 424 — 191 Our scenario combining 2015 1,531 332 — 77 2016 1,733 238 — 7 benefit and tax changes would make an esti- mated 119,000 claimants Figure 13 (about 7 percent of the How Different Program Scenarios 2009 total) ineligible for Affect Average Weekly Benefit Amounts UI benefits. (In Billions) Figure 13 compares Scenarios the impact of our benefit Current Benefit Combination of Benefit and Year Law Decreases Alone Tax Changes changes on the average weekly benefit amount, 2011 $309 $253 $275 2012 320 205 250 as compared to current 2013 334 189 243 law. The benefit decreas- 2014 350 184 241 es we tested would re- 2015 367 183 242 2016 384 184 243 duce the average weekly LegisLative anaLyst’s Office 19 an LaO RepORt benefit amount for UI claimants to below the na- almost quadruples the average employer cost per tional average amount, which was around $300 employee in 2012 (to about $1,600 per employee) in 2008. As Figure 14 shows, the benefit change and more than triples the average UI tax rate for scenarios we analyzed would also substantially employers (to 2.8 percent of employee wages). reduce the total amount of benefits paid collec- These employer costs would fall below $1,000 in tively to UI recipients, as compared to current 2014, and the tax rates would drop to the lowest law. In the out years, in particular, total benefit contribution schedule in 2016. payment levels under the scenarios would be Relying on a combination of tax and benefit significantly lower compared to current law. changes would about double the average em- ployer contribution in the short term (to around Impact on Employers $800 to $900 per employee). The average tax Addressing the UI insolvency through benefit rate would also double in the short term to about changes alone would, of course, not affect employ- 1.5 percent of employee wages. However, as in ers. However, our scenarios involving proposals to address the problem Figure 14 through tax increases How Different Program Scenarios alone, or a combination of Affect Total Benefit Payments tax and benefit changes, would affect (1) the tax (In Billions) rates that employers would Scenarios pay and (2) the wage Current Benefit Combination of Benefit and Year Law Decreases Alone Tax Changes base to which those tax 2011 $10.7 $8.7 $9.5 rates would be applied. 2012 10.1 6.4 7.8 As shown in Figure 15, 2013 10.4 5.8 7.5 the scenario relying on 2014 10.7 5.6 7.3 2015 11.1 5.4 7.2 increases in UI taxes alone 2016 11.4 5.4 7.1 Figure 15 California’s UI Benefits Near Average of Other Larger States Combination of Benefit and Current Lawa Tax Increases Alone Tax Changes Contribution Effective Contribution Effective Contribution Effective Year Per Employee Tax Rate Per Employee Tax Rate Per Employee Tax Rate 2011 $418 0.8% $1,503 2.7% $800 1.5% 2012 444 0.8 1,621 2.8 883 1.5 2013 458 0.8 1,139 1.9 835 1.4 2014 467 0.8 918 1.5 785 1.3 2015 476 0.8 936 1.4 753 1.2 2016 485 0.7 958 1.4 746 1.1 a Under current law, the maximum annual employer contribution per employee cannot exceed $434. However, some employees work more than one job or change jobs within the same annual contribution period, which can result in overall higher UI contributions. 20 LegisLative anaLyst’s Office an LaO RepORt the scenario described above, average employer the Legislature will need to make substantial costs would decrease in the out years as economic changes to the state’s UI system. Below, we sum- conditions and the UI fund balance improved. marize our findings from these scenario analyses. As Figure 16 shows, the tax change scenarios Decreasing UI Benefits Alone Cannot we analyzed would substantially increase the Address Fund Insolvency in the Near Future. total level of employer contributions paid, as The illustrative scenario regarding decreased UI compared to current law. In the short term, in benefits alone would not resolve the problem by particular, total employer contributions under 2016. Benefit payments would exceed employer the scenarios would be significantly higher than contributions during 2011. However, beginning in compared to current law. 2012, contributions would exceed benefit pay- We note again that, regardless of the sce- ments, and the state would make slow progress nario, employers could face gradual federal UI toward reducing the debt to the federal govern- tax increases (as summarized earlier in Figure 5), ment. A $4.3 billion debt would remain in 2016 beginning as early as 2012, if the UI fund contin- and an unanticipated increase in unemployment ues to be insolvent. This would be in addition to would threaten the path to solvency after 2016. the state UI tax increases described above. Options Involving UI Tax Increases Would For simplification, the discussion above Quickly Improve the Fund Condition. Both focused on how tax increases would impact em- the scenarios in which we increased UI taxes, ployer costs. We would point out, however, our either alone or in combination with some benefit review of the economic literature suggests that in decreases, show that the state could quickly im- the long run, these costs would largely be passed prove the fund condition by raising revenues to a to workers in the form of lower compensation. level that could cover benefit payments. Potential adverse consequences of this tax increase are Findings From Scenario Analyses discussed below. The results of the various scenarios we tested Tax Increases Could Hurt California’s Com- to try to achieve UI fund solvency indicate that petitiveness. As our scenario analysis indicates, in order to achieve UI fund solvency in the Figure 16 short term, employers How Different Program Scenarios would face significant tax Affect Total Employer Contributions increases. The magni- (In Billions) tude of the tax increases Scenarios shown in our scenarios Current Benefit Combination of Benefit and Year Law Decreases Alone Tax Changes is so significant that they could harm California’s 2011 $4.9 $17.7 $9.4 2012 5.3 19.5 10.6 economic competitive- 2013 5.6 13.9 10.2 ness when compared to 2014 5.8 11.3 9.7 other states. California 2015 6.0 11.7 9.4 2016 6.2 12.2 9.5 employers’ average UI LegisLative anaLyst’s Office 21 an LaO RepORt tax is already higher than the national average insolvency problem would involve increasing and the average for the ten largest states. Our taxes significantly more. analysis indicates that addressing the current fund StratEgiES to addrESS thE ui Fund inSolvEncy As we described, the magnitude of the UI Make Both Tax and Benefit Changes fund insolvency is so great at this point that it We would recommend against solutions that poses significant financial risk for the state and go as far as the illustrative scenarios presented employers. Below, we outline some strategies for above in which benefits would be decreased the Legislature to consider as it weighs various po- alone or taxes would be increased alone to tential solutions to address the UI fund insolvency. address the UI fund insolvency. We do think, however, that some combination of tax and Attempt to Minimize Impacts benefit changes must be implemented soon to On the Economy improve the UI fund condition. Therefore, we As our analysis of the different scenarios recommend the Legislature consider using our demonstrates, the Legislature would need to example of combining UI benefit decreases with make substantial UI tax and benefit changes to tax increases as a starting point for a possible achieve fund solvency in the short term. How- solution. As that specific scenario illustrates, ever, severe UI tax increases on employers and/ however, fund solvency may take several years to or benefit reductions for unemployed individuals achieve, so there are likely to be some state costs would negatively impact the state’s recovering from continued federal borrowing to cover UI economy. That said, failure to adequately address benefit payments. We believe this is a reasonable the fund insolvency would increase the financial trade-off that the Legislature should consider as burden on the state due to ballooning interest part of its approach. payments that the state would have to make to Potential Tax Changes. As we previously the federal government for continued borrowing. pointed out, the current UI financing structure Because these interest costs would likely be paid caps revenues at about $6 billion annually. from the General Fund, it could lead to reduc- Although California employers already pay tions in other state programs or increases in other above-average UI taxes, we recommend that the state revenue sources. The Legislature should Legislature increase UI taxes by the amount that also carefully consider what actions should be would be sufficient to (1) improve the UI fund taken now, in the context of the recovering condition in the short term and (2) create a more economy, versus those that could be taken later flexible financing structure that can achieve and when the economy is in a better condition. maintain a healthy fund balance in the long term, especially during economic downturns. 22 LegisLative anaLyst’s Office an LaO RepORt Similar to the Governor’s November 2008 The Legislature should also consider indexing proposal, we recommend increasing both the these monetary requirements to changes in aver- taxable wage base and tax rates. To minimize age wages in order to keep eligibility require- the impact on the economy, employers’ UI taxes ments more up to date over time. should probably not be more than doubled. Another component to review is the aver- Increasing the taxable wage base and maximum age duration of benefits, which is an area where tax rate to the levels proposed by the Governor’s California has averaged about two weeks longer November 2008 proposal or near the national than the national average for the last few years. average (as shown in Figure 8) would about The Legislature may wish to look into what types double employers’ UI costs in the short term. of program components may be contributing to Beyond increasing the taxable wage base this longer than average duration of UI benefits and tax rates, the Legislature may wish to consid- in California. er other tax policies to reform the UI system. For Implement Solutions Quickly example, it could consider indexing the taxable Yet Carefully wage base to average annual wages, which may keep the UI financing system more fluid and in Because the magnitude of the UI fund in- line with changing economic conditions. solvency is so great, the Legislature should act Potential Benefit Level Changes. As previ- quickly to improve the fund condition. Ideally, ously discussed, although California’s actual aver- some changes should be adopted this year. This age weekly UI benefit amount is slightly above is because businesses and payroll processing the national average, it is lower than the national companies need time to prepare for changes in average when taking into account California’s tax rates and/or the taxable wage base prior to high wages and high cost of living. Therefore, we the start of calendar year 2011. Mid-calendar would advise against making drastic reductions year changes pose administrative difficulties for to the weekly benefit amount. That said, in light employers. Although not ideal, it is possible to of the UI fund condition, we recommend that the change the tax rates after the start of the fiscal Legislature consider some level of benefit reduc- year. As we discuss below, the Legislature may tion, either by decreasing the maximum weekly ultimately need to phase in a series of changes benefit amount and/or the wage replacement over multiple years. Legislative action during the rate. fall of 2010 to improve the fund condition during Potential Eligibility Changes. There are 2011 would in part lessen the need for stronger other programmatic changes, such as updat- action in later years. ing or altering various eligibility provisions that Consider Different Short-Term and could be made to decrease total UI benefit costs. Long-Term Strategies For example, we recommend that the Legisla- ture increase the minimum monetary eligibility The Legislature may wish to consider differ- requirements to qualify for UI benefit payments, ing strategies to address the UI fund insolvency as these provisions have not been adjusted since in the short term versus the long term. For ex- 1992 to account for changes in average wages. ample, as our scenario analyses indicate, some of LegisLative anaLyst’s Office 23 an LaO RepORt the difficult tax changes that will be necessary to system. By inside, we mean changes to UI ben- quickly bring the fund back into solvency could efit levels, eligibility standards, and/or employer be scaled back after a few years when the fund taxes. As described earlier, the UI insolvency can balance is healthier. The Legislature could gradu- be divided into two parts: (1) the ongoing deficit ally phase in various changes to the UI system created from benefit payments exceeding em- over time, although this approach would inevita- ployer contributions and (2) the outstanding debt bly mean that the state would face larger Gen- of about $20 billion owed the federal govern- eral Fund impacts for paying back interest to the ment. The first part must be solved within the federal government on loans received to sustain UI system. The Legislature needs to bring benefit the system. At a minimum, the Legislature should payment and employer taxes into line. However, take prompt action to bring UI benefit costs and once the Legislature has balanced the program’s tax revenues into line so that the accumulated inflows and outflows, there are options outside deficit does not continue to grow. This would the UI system for repaying the loan to the federal eliminate the need for additional federal bor- government. These outside options include rowing and would cap the state’s interest costs (1) creating new revenue sources of a time-spe- at current levels. In the long run, the Legislature cific duration to pay down the debt over time, should modify the UI financing and benefit (2) dedicating existing revenues to loan repay- system so that it can be self-sustaining through ment, and (3) issuing bonds. Other states have periods of economic contractions and expansion. issued bonds rather than seek federal loans when their UI programs became insolvent. This was Considering “Outside” Options typically because the debt-service costs on the Regarding the State’s UI Debt bonds was less than the interest charged by the This report has focused on addressing the UI federal government. insolvency by making changes “inside” the UI LAO Publications This report was prepared by Minsun Park Meeker, and reviewed by Todd Bland. The Legislative Analyst’s Office (LAO) is a nonpartisan office which provides fiscal and policy information and advice to the Legislature. To request publications call (916) 445-4656. This report and others, as well as an E-mail subscription service, are available on the LAO’s website at www.lao.ca.gov. The LAO is located at 925 L Street, Suite 1000, Sacramento, CA 95814. 24 LegisLative anaLyst’s Office