Incomplete experience rating in state unemployment insurance

Monthly Labor Review, Nov, 1984 by Denton Marks

By now it is well established that the existence of unemployment insurance (UI) affects decisions on both the supply and demand sides of the labor market. Theoretical work on such effects has appeared within the past decade, and empirical tests of the basic theoretical propositions have appeared more recently. On the supply side, the tendency of the availability of UI benefits to extend the duration of nominally involuntary unemployment and perhaps to increase labor force participation and improve the success of job search as evidenced by wage gains of job changers has been examined and supported by recent research.

A link between the existence of UI and labor demand has been demonstrated by examination of the system of experience rating--or incomplete experience rating--used to finance benefits in most States. In the United States, States finance UI benefits through a payroll tax on covered employers. In the context of such a financing system, experience rating is the use of payroll tax rates that change inversely with the stability of an employer's labor demand, where that stability is indicated by a measure such as a "reserve ratio"--the employer's accumulated contributions to the system less his accumulated liability in the form of paid-out benefits, with the difference expressed as percentage of his average taxable payroll over some period. Incomplete experience rating limits the allowable tax rates to a relatively narrow range; for example, no State tax rate currently exceeds 10 percent of taxable payroll, and most States have a nonzero minimum rate.

The intuitive argument about the effect of incomplete experience rating on labor demand, or more particularly layoff rates, begins with the realization that many employers assigned either the minimum or the maximum UI payroll tax rate have a zero marginal tax cost of an extra layoff. Those assigned the minimum rate will be contributing to the system regardless of their benefit liability. To the extent that they accumulate reserves beyond those required to maintain their minimum rate assignment, they may have an incentive to draw down the excess through extra layoffs, or "UI holidays." Employers already at the maximum rate cannot be further penalized for additional layoffs; thus, they may also have an incentive to provide UI holidays as part of their contract (implicit or explict) with their workers. Any resulting benefit liability that exceeds their own contributions is paid from the net contributions of other employers (cross-subsidization).

While this connection has been well established theoretically, empirical support has been scarce because of a lack of data. However, the three studies that have been published support the existence of such a relationship. Indeed, the most recent of these finds that the increase in temporary layoff unemployment resulting from the implicit cross-subsidization that incomplete experience rating allows is not only larger but also statistically more significant than the "supply side" unemployment effect of the level of the benefits. The author of that study concludes that, "without chaning benefit levels available to unemployed workers, a significant reduction in layoff unemployment could be achieved by changing the incentives offered by current UI [financing] laws." Moreover, he finds that "the impact of the unemployment insurance subsidy on layoff unemployment is powerful--the imputed subsidy accounts for more than a quarter of all layoffs in the data. . . ." Unfortunately, none of the recent studies considers the incentive that employers assigned the minimum rate have to increase their layoffs, although there is some unpublished evidence suggesting that this effect is small or nonexistent.

The growing body of evidence that incomplete experience rating does increase the amount of layoff unemployment leads one to ask what proportion of employers are subject to the layoff incentives of such cross-subsidization, and, perhaps more importantly, how long particular employers remain at tax rates that allow them to be implicitly subsidized? These issues are important, for persistent subsidization of some employers indicates that the employment stabilization incentives built into the UI system are not working, and it may lead to distortions in the industrial and occupational structure of a State's economy.

To address these questions, I analyzed fiscal 1975-78 UI data for a random sample of more than 17,000 New Jersey employers. The results, presented below, show that, at any time, large proportions of employers are assigned the minimum and maximum tax rates. More importantly, most of these employers have a low probability of moving to any other rate category over time. Indeed, most of them can be assumed to be assigned a limiting rate permanently, thus precluding their effective experience rating. Distribution of employers by rates

Table 1 shows the distribution of employers in the sample by tax rate category for each of the study years. "Graded" employers are firms for which the State had sufficient payroll and turnover information to assign a UI tax rate. The group consists of employers at the minimum rate (1.2 percent of taxable payroll); those at the maximum rate (6.2 percent); and those taxed at one of a range of ra tes in between the two limits. "Other" employers are those to which a rate could not be assigned in the usual manner, either because of inadequate data or their lack of experience in the system. "Inactive accounts" are employers that were not in business during a given year.