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States’ Unemployment Insurance Funds Founder After Years of Poor Planning

Editor's note: Yesterday we started our series -- in partnership with public radio's Marketplace -- about the history and limitations of the U.S.'s patchwork unemployment insurance system. Today we're looking at how state unemployment trust funds are financed -- and how that contributed to the current crisis.

A state worker points out phone numbers for unemployment insurance at the state unemployment and career office in San Francisco. (Paul Sakuma/AP Photo)

It used to be, unemployment insurance meant a sturdy back and a jalopy big enough to fit the whole family. That changed in 1935, when the government started offering unemployment insurance, and states began to save when times were good so there was money to spend to help workers and stimulate the economy when times were bad.

In all but a handful of states, it no longer works that way.

Fourteen states have already run out of funds to pay unemployment insurance claims and taken out a total of more than $8 billion in federal loans to cover the shortfalls. At least 18 more states are in danger of exhausting their unemployment insurance trust funds.

States with empty unemployment insurance trust funds have pointed to the severe recession as the cause for their plight, but a closer examination of their trust funds shows underfunding and poor planning as the main culprit. Instead of building up reserves during good years, legislatures in these states yielded to political pressure for high benefits and low taxes. The result: dangerously low trust fund balances.

Now, states with bankrupt trust funds will have to increase taxes or cut unemployment benefits at the worst possible time -- during a recession.

"This is not a very smart way to run a railroad, because you want benefits to be available quite freely when unemployment rates go up, and you don't want to raise taxes on employers during a recession," said Gary Burtless, an economics expert at the Brookings Institution. "There used to be rules most states abided by, but those standards kind of went the way of the dodo bird."

Federal loans will ensure that states can keep mailing out benefit checks. But the loans pass costs along to federal taxpayers, including people who live in states where unemployment insurance is sufficiently funded. Nor will they solve the long-term unemployment insurance crisis. Taxpayers in states that have borrowed money will have to foot the bill for tens of millions of dollars in interest charges, which must be paid out of the state's general budget because rules prohibit using unemployment insurance funds.

At the end of 2007, after years of increasing employment and before the current recession hit, 33 states had less than a year's worth of reserves in their trust funds, even though many experts recommend 18 months' worth. Four states had negative balances in the years before the recession started.

See which states were the first to run out of money for their unemployment systems.By the end of 2008, 21 states had less than 6 months of reserves in their trust fund and tax revenues that were not keeping up with the money spent on benefits.

Consider Indiana, which has already borrowed more than $700 million to cover the negative balance in its trust fund account. In 2000, looking at a $1.6 billion surplus, the General Assembly lowered its tax rate and increased benefits; since then, the trust fund has been slowly bleeding.

"Even during good economic times it was still being systematically drained," said Marc Lotter, spokesman for the Indiana Department of Workforce Development. "The current economic crisis did not create the problem, it exacerbated it."

To fill the hole, Indiana recently enacted a 35 percent tax increase on businesses, but the chief financial officer of the state's unemployment insurance system said even that will not be enough to repay the federal government in time to avoid penalties.

The federal government's stimulus package gave states extra time to pay off the loans. But by 2011, Washington will start charging states interest at a rate of about 5 percent, which must be repaid out of states' general budgets.

Unemployed workers in Indiana could take another hit. The original version of the state's bill would have reduced benefits, restricted eligibility and allowed some employers to opt out of the system altogether, making their workers ineligible for benefits. The provisions were taken out under pressure from organized labor, but business leaders have vowed to continue the fight to cut benefits.

California increased workers' benefits in 2001, but it only taxes the first $7,000 of wages, the federal minimum that has not increased in 25 years. Now, the state projects it will have to borrow nearly $18 billion from the federal government by the end of 2010 to keep its unemployment fund solvent. If the state is not able to pay back that amount by 2011, it faces a $600 million annual tab that covers just the interest.

To plug the leak, California Gov. Arnold Schwarzenegger has proposed both increasing taxes on businesses and reducing benefits for hundreds of thousands of workers.

"Asking jobless workers to make sacrifices, especially during a recession, is kind of like shooting yourself in the foot," said Rick McHugh of the National Employment Law Project, a group that advocates for low-income workers. "It defeats the purpose of having unemployment insurance, which is to stimulate spending."

There are 53 separate trust funds in the U.S. (the 50 states, the District of Columbia, Puerto Rico and the Virgin Islands), the artifact of a compromise struck in 1935 between President Franklin Roosevelt and state governments, many of which were opposed to the idea of unemployment insurance altogether.

As a result, states are given wide latitude to administer and fund their own systems. There is no minimum balance for funds and no requirement that taxes be high enough to maintain solvency.

States have been through several unemployment-insurance boom and bust cycles before.

The first federal bailout of unemployment insurance funds occurred after the deep recession of the 1970s plunged the unemployment insurance system into crisis: Some 30 state trust funds ran out of money.

The Carter administration approved interest-free loans, and states took advantage of them. By 1983, long after the recession was over, about 30 states owed $27 billion (in today's dollars) and showed little intention of paying it back. Even Connecticut, the richest state in the country, owed money.

Finally, Congress cracked down on states, giving them a one-year grace period before smacking them with a relatively high interest rate. This stopped the gravy train, and by the end of the 1980s, all the loans were paid off. But in all but a few states, the idea of resourceful ants saving for winter was gone forever. In some states, supply-side economic theory was applied to justify a low balance.

Unemployment benefits go up as wages go up, because benefits are defined as a percentage of a worker’s earnings. This means the amount flowing out of the trust fund tends to increase year after year.

In all but 13 states, however, increases in funding are not automatic. They must make their way through the state legislature, where the idea of maintaining a high tax rate or increasing taxes to set aside money that might be used in the future is not very sexy. Businesses are a powerful lobby opposing tax increases, while organized labor tends to resist any decreases in benefits.

"There's a powerful dynamic in state capitals," said Rich Hobbie, executive director of the National Association of State Workforce Agencies, the group that represents state trust fund managers.

Businesses are "very interested in keeping their taxes as low as they possibly can, so they will always argue for low reserves because they fear that if reserves get to a certain level, politicians will raise benefits -- they know that will result in higher taxes for them later," he said.

And in committee rooms, where decisions are made by a handful of state legislators who may or may not be familiar with the issues surrounding unemployment insurance and the careful math involved, the voice of business booms loudly.

"Often there's not really a lot of careful systemic analysis at the state level," said Burtless, of the Brookings Institution. "You have a lot of ill-informed state legislators and only one side of the case being upheld by employers."

Many states underfund their systems. In 2008, 21 states had both less than 6 months of reserves in their trust fund and an unsustainable tax rate.In addition to having a low tax rate, many states only tax a small portion of earnings. The federal minimum, that states tax the first $7,000 in workers’ wages, was set in 1983, when the average income was about $15,000. Now it is nearly $50,000, so states find themselves paying to replace ever-higher incomes, with a tax base that has not grown.

About 16 states have maintained a reasonable tax base by indexing the taxable wage to increases in overall earnings. In Utah, for example, the first $25,000 in wages gets taxed, an amount that increases every year. But in Indiana, the taxable wage is still at the federal minimum of $7,000. In New York and California, two of the states with the highest wages, the taxable wage is nearly as low.

Contrast this with Oregon, which, despite having one of the nation’s highest unemployment rates, has nearly 18 months of reserves, even after a year of recession.

As the result of an indexed wage base, instituted in 1975 after the fund went bankrupt, the first $31,300 of workers’ income in Oregon is now taxed, a figure that increases automatically every year.

"We've kind of become the envy of other states," said Tom Byerley, assistant director for Oregon's unemployment insurance programs. "The legislature doesn't have to go in and change anything; it chugs along on its own. They hold that fund pretty sacred and don't mess with it."

Doug Holmes, president of UWC -- Strategic Services on Unemployment and Workers’ Compensation, a business-supported group that consults with states on unemployment insurance issues, said blaming businesses is not fair.

"Is there a pressure point at which business in a particular state says we need to have a balance here and exert pressure? Certainly," Holmes said. "But I don't think you can make the case that these trust funds are becoming depleted simply because the Chamber of Commerce has lobbied for this."

Employers are hurt more than anyone when trust funds dry up and emergency tax increases are instituted, he said. State legislatures were urged to fund programs sufficiently, but not so highly as to drive business away to neighboring states.

When Holmes met with state officials in the past, he was especially critical of the U.S. Labor Department’s calculations that used the severe 1980s recession as a way to gauge how much money states should squirrel away, because he believed severe unemployment was a one-time effect of the collapse of U.S. manufacturing.

He said he'd encouraged states to ask, "'What do we need in the way of a balance to cover a reasonably foreseeable recession?'"

"Of course," he added, “I don't think anyone foresaw the recession we're having."

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