An Experience-Rated UI System Reduces Claims

Summary of working paper 6808
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... the introduction of experience rating lowered the level and the seasonality of UI claims and the seasonality of unemployment.

Most employees know whether they are eligible for unemployment insurance (UI) if they should be laid off. But fewer may know that the insurance is paid for indirectly by a state tax on the payroll of their employers. In Using a Natural Experiment to Estimate the Effects of the Unemployment Insurance Payroll Tax on Wages, Employment, Claims and Denials (NBER Working Paper 6808) , Patricia Anderson and Bruce Meyer take advantage of changes that occurred in Washington state to analyze the effects of that payroll tax.

During the 13 years from 1972 through 1984, all employers in Washington paid the same UI tax rate. It was either 3 or 3.3 percent of their payroll, depending upon the year. The state had no "experience rating;" that is, all employers paid the same payroll tax rate whether or not in the past they had laid off workers frequently or rarely. Some employers, perhaps with seasonal variations in their work load, will lay off workers in the slack period, and UI will carry those workers over until the next busy period. Workers thus get a combination of paid work and UI-supported time off. This means, though, that employers who seldom lay off workers and yet contribute to the state UI trust fund at the same tax rate are subsidizing the firms and workers with frequent layoffs

During this same period, the U.S. Congress passed the Tax Equity and Fiscal Responsibility Act of 1982. It required all states to have a maximum UI payroll tax rate of at least 5.4 percent by 1985. Such a uniform rate, however, would have heavily overtaxed most firms in Washington and thus generated a huge surplus in the UI state trust fund. So, the state legislature passed a law reinstating experience rating in 1985, so that some firms would pay a lower tax rate and others the maximum. Also, the tax base -- the maximum amount of an employee's wages subject to the UI tax -- was reduced to $10,000 in 1985 from $12,000 in 1984.

The combination of these measures meant a sharp change in the cost of UI to many employers. Some firms saw an immediate increase in their tax rate from 3 to 5.4 percent. Others saw a decrease from 3 to 2.5 percent. Changes in subsequent years led tax rates to range from 0.36 to 5.40 percent. These changes in both the cost of employing workers and of laying them off were, of course, noted by employers. It altered the way they dealt with layoffs and UI claims, just as economic theory would anticipate.

Using UI data from Washington and some comparisons with similar data from Oregon and Idaho, Anderson and Meyer reach several conclusions. One is that employers overall passed on the higher tax to their workers in the form of lower wages. However, since a single firm faces price and wage competition in its specific market, it may not be able to pass on the extra tax cost fully to its workers through smaller pay raises.

Another finding of Anderson and Meyer is that in Washington, the introduction of experience rating lowered the level and the seasonality of UI claims and the seasonality of unemployment. Some employers found it cheaper to keep employees on staff steadily (and more expensive to lay them off, even if only seasonally), because their tax rate would go up in subsequent years.

Further, experience rating gives employers an incentive to "police the system" and contest invalid claims for UI. If they don't, their tax rate rises in the future. In Washington, denials of UI to workers separated from their firms rose by anywhere from 51 to 66 percent, depending on the year. Anderson and Meyer suggest that experience rating increased general economic welfare in the state by stabilizing unemployment and reducing UI claims.

David R. Francis