The Impact of Unemployment Claims on State Employment Taxes

It is difficult to observe – let alone quantify – the impact of unemployment claims on a company’s state unemployment taxes. This can cause a person to question whether the effort involved in processing unemployment claims is cost-effective.  This is an attempt to clarify the cause and effect relationship (there is indeed such a relationship) between claims and taxes.

First, benefits paid to a UI claimant are taken into account in the UI tax rate calculation in every state except Alaska. This process is referred to as “experience rating” or “merit rating.”  Employers whose workers make the greatest use of the UI system inevitably are assigned the highest UI tax rates.  Such employers may be in seasonal industries, declining industries, cyclical industries, or high turnover work environments.

UI tax rates are reassigned on an annual basis, taking into account annually updated information regarding an employer’s UI benefit charges, payroll, and other factors. In every state except four (NH, NJ, TN, and VT) tax rates are assigned on a calendar year basis.  However, a comparison of your tax rate(s) from one year to the next is not an accurate measure of the cause and effect relationship between claims and taxes.

Changes in your payroll also impact your tax rate in every state. The ratio of your benefit charges to payroll (“benefit ratio”) or your reserve account balance to payroll (“reserve ratio”) is the basis of your rate.1  Increases or decreases in your taxable payroll can partially or completely offset the effect of changes in benefit charges. The benefit charges must be isolated to avoid a mistaken conclusion.

In the short term, the claims/tax relationship can also be obscured by changes in tax rate tables or state-wide adjustment factors used in the tax rate calculation. State tax laws contain mechanisms to increase or decrease tax rates depending on the solvency of the state UI trust fund.

There can be a multi-year delay between the payment of benefits and the tax impact. The delay is partially caused by the lag between the computation date (the cut-off date for gathering the relevant data) and the effective date of the next tax rate.  Most states use a computation date of June 30 to compute the employer tax rates for the following calendar year.  UI benefit charges incurred after the computation date do not affect the tax rate calculation for the following rate year, but such charges will be included in the calculate for future rate years.

For example, assume an employee in Missouri is terminated for lack of work in October of 2017, files a claim, and begins receiving UI benefits chargeable to the employer that terminated him. The employer’s tax rate for 2017 is already established and does not change as a result of the claim.  Further, Missouri uses a computation date of June 30, so the benefits paid to this employee will not be used in the 2018 tax rate calculation.  However, the benefit charges will be used in the 2019 rate calculation and future rate calculations.

Finally, tax brackets also muddle the connection between claims and taxes in the short term. In about half the states, a range of reserve ratios results in the same tax rate for any given rate year. A claim resulting in benefit charges of $10,000 may not result in a higher tax rate for the following rate year because it does not immediately push the employer into a higher tax bracket.  For another employer, whose tax rate is right on the upper edge of the tax bracket, benefit charges of $100, or even less, can move the needle, resulting in a tax increase that greatly exceeds the $100 in benefit charges.

Because of all the moving parts in an annual tax rate calculation, the most meaningful way to analyze this cost is to take a different approach. First, consider that UI taxes must at least be sufficient to fund all UI benefit payments on a continuing, prospective basis for the UI program to sustain itself in its current form as an employer-financed program.  Collecting the “right” amount of UI taxes from employers is problematic, because the amount of UI benefits paid can vary significantly from one year to the next.

Your UI tax payments must include a solvency factor, over and above the cost of benefits paid, to avoid the necessity of borrowing funds or increasing employer taxes during recessionary periods when tax increases can least be afforded.2  State tax laws are designed to generate revenue that exceeds normal benefit payouts by some cushion to account for fund solvency even though it is usually not identified on your tax rate notice.

Another “surcharge” is factored into your tax rate because certain UI benefit payments are incurred that are not charged to any specific employer, and these costs also have to be recovered. For example, let’s assume the Missouri employer mentioned above went out of business, and a total of 150 employees were laid off.  UI claims filed by these individuals are chargeable to the defunct employer’s tax account, but such charges will not generate any addition tax payments. The employer’s tax rate for the current year is already established.  The tax rate for next year is of no consequence because the employer is out of business and will report no payroll and pay no UI tax.  Benefits paid to these 150 people will have to be funded collectively by the other, active employers in Missouri.  This is an example of a “socialized cost.”

Other socialized costs include benefits paid to claimants but not charged to a specific employer’s tax account, and benefits paid to a claimant and charged to the account of an employer that already has the maximum tax rate (referred to as ineffectively charged benefits).

Nationally, twenty-nine percent of all UI benefit payments are not directly charged to an active employer or are ineffectively charged; therefore not affecting any particular employer’s UI tax rate.3  Nevertheless, the assignment of employer tax rates must account for and recover these payments.  By the way, the percentage of socialized costs has gradually increased in recent years.  Benefit eligibility has expanded to include such situations as a quit because of domestic abuse in many states.  While the claim is approved, the employer is generally granted relief from charges, resulting in expanded socialized costs.

Adjustments for fund solvency and socialized costs can and do vary widely from state to state and from year to year. For example, last year the socialized costs were 18% of all benefit payments in Michigan and 56% of all benefit payments in Mississippi.

The bottom line is that the following tax consequences will likely result from a chargeable claim:

  • 100% of the employer’s benefit charges will be built into the tax rate calculation.
  • 29% of the employer’s benefit charges will be added to the tax rate calculation to fund socialized costs.
  • 10% of the employer’s benefit charges will be added to the tax rate calculation to provide a cushion for periods of high benefit charges.

For a multi-state employer, it would be reasonable to assume that every dollar of UI benefits paid to one of your former employees and charged to your tax account will result in $1.39 in future UI taxes. If UI benefits are paid erroneously or improperly, the real cost to the employer will sooner or later exceed such payments by a wide margin.  You may never notice it because it is a “stealth expense,” incurred over an indeterminate period and masked by other variables.

If you ever find yourself questioning the relevancy of an effective unemployment claims management process, rest assured that your efforts are protecting your company from a cost that is often hidden, but real and significant.

As always, if there are any questions please do not hesitate to contact us.

1 The ratio is slightly different in Delaware and Oklahoma, which use a benefit-wage ratio formula, but this formula also takes claims into account.
2 State unemployment agencies have access to credit (federal loans and/or bonds) to fund shortfalls, but such funds must be paid back ultimately by means of employer UI taxes.
3 U.S. Department of Labor, Significant Measures of State Unemployment Insurance Tax Systems, Page 64, August 2015.

Josh Kendall

Author Josh Kendall

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