Tax Policy – How the Federal Government and the States Could Help Save Small Businesses Through Temporary UI Tax Adjustments
Governmental responses to the coronavirus outbreak will require creativity and flexibility—and one aspect of that may involve temporarily rethinking how we structure not only unemployment insurance (UI) benefits but also the taxes that pay for them. As this public health crisis unfolds, it will be necessary to ensure that (1) those who lose their jobs have access to extended unemployment benefits that allow them to remain home throughout the crisis if they cannot be employed in a sector that is consistent with telework or appropriate social distancing, and (2) the taxes that fund unemployment insurance don’t overly burden businesses struggling to survive. It’s hard to accomplish both aims. To do it, the states will almost certainly require federal assistance.
What follows is, for the most part, a thought experiment. It is offered as an idea that might prompt fruitful discussion. Under the present circumstances, however, there may well be a case for states temporarily revisiting how the UI tax structure works to help see affected small businesses through a lockdown period. The federal government and states could work together to ensure that supplemental federal funds serve these dual purposes.
To explain what I mean, first let me provide a very brief and admittedly oversimplified explanation of how UI taxes are currently levied, because it’s not straightforward. From there, I’ll move on to some preliminary thoughts on temporary revisions as we go through the COVID-19 crisis.
The UI system is a joint federal and state effort and begins with a 6 percent federal payroll tax levied under the Federal Unemployment Tax Act (FUTA) on the first $7,000 of wage income (called the taxable wage base). This tax exists primarily as a mechanism to encourage states to maintain their own effective UI tax regime, and to raise revenue to backfill state efforts when they fall short. The federal government accomplishes this purpose by offering a credit against up to 90 percent of the federal tax, called the FUTA credit, in states with solvent unemployment insurance funds.
This means that, in a state that is doing everything right, the federal tax is only 0.6 percent on the wage base, or a maximum of $42 per year per employee (0.6 percent x $7,000). The value of these credits is diminished, however, when states fall short. Particularly, when states take out federal loans to cover a surge of unemployment insurance payouts, the credit’s value is rolled back, exposing in-state companies to higher taxes to bridge the gap created by insufficient state funding.
The bulk of unemployment insurance taxes are imposed by the states themselves, and these systems are incredibly complex. There are, to begin with, multiple rate schedules, and businesses are subjected to more or less favorable rate schedules based on their history of layoffs or seasonal employment. This history is known as a business’ “experience rating,” and businesses that have a strong history of few or no layoffs pay less than those that often let employees go.
This makes a great deal of sense in normal times, since unemployment insurance is essentially an employer-funded social insurance program and we want to encourage businesses to do what they can to keep people employed while charging companies more if they are “bad actors” that lay off their employees more regularly. These are not, however, ordinary times, and as much as we would all like restaurants, gyms, theaters, and a wide range of other small businesses to pay their employees indefinitely even if the business is temporarily closed, the reality is that many of these businesses are being forced into layoffs due to closure orders. The goal here should be to help both the laid off workers and the business, not to punish struggling companies for those layoffs in these extraordinary times.
When UI funds are drawn down, moreover, many states impose what are known as solvency taxes—a surtax on all businesses (regardless of experience rating or whether they’ve made any reductions in their workforce) to help replenish the fund. Again, this makes a certain amount of sense, as benefits have to be funded somehow. Still, it arguably represents a failure to prepare adequately, backfilled by raising taxes on businesses at the least opportune moment. At a time when many businesses may not be able to operate at all, it seems particularly perverse.
This seems to suggest several potential courses of action:
- The federal government could relax the rules on the FUTA credit, either temporarily reducing the percentage reductions, lowering states’ requirements to avoid a reduction, or extending repayment periods to keep the effective rate from rising on businesses.
- Federal backfilling of state funds could enable—and perhaps expressly incentivize—states to freeze experience ratings for some or all businesses, or to temporarily reduce rates on less favorable schedules to make them diverge less from standard or most favorable schedules.
- If states have greater access to federal funding or have the fiscal capacity to fund the account in other ways, they could try to suspend or otherwise avoid the imposition of a solvency tax until sometime after the recovery has begun.
This would, of course, be in addition to joint federal-state efforts to expand eligibility, cover the costs associated with so many new people entering the system, and enhance the federal funding of extended benefits. Ideally, these policies would work in tandem, extending unemployment compensation to all those who will need it without placing all the added burden on businesses that are forced to suspend operations. The hope is to ensure that these laid off workers have a company to return to once the immediate crisis has lifted.
Clearly, any such changes would be expensive and have their drawbacks, so they must be temporary in nature—but in the long run, they could prove far less costly than the alternatives.