Despite complex tax schedules and funding strategies, there are times when a state’s unemployment insurance fund will be insufficient to cover its costs. Typically, this happens during a prolonged recession, when claims for benefits are high and contributions to the fund diminish. Although most states rely on some type of solvency provision to prevent this from occurring, such measures are not always enough.
When a state does find itself in the position of insufficient funds, it may do one of two things. The first and most common course of action is to borrow money from the United States Treasury. The second (more recent and less common) option is for a state to issue bonds. Both methods of securing revenue have their strengths and weaknesses.
The Social Security Act allows states to borrow funds as needed to maintain their unemployment insurance programs. These loans come in the form of advances and do not require the states to pay interest if the funds are repaid within a specific period of time. If repayment is not completed within the specified timeframe, the state is put onto a repayment plan entailing interest and minimum required payments. If the state is unable to make those payments, the federal government has the option of recouping its money through special taxes added to employers’ unemployment insurance taxes.
For short-term borrowing needs, treasury loans can be ideal. They offer an instant flow of cash. At the same time, they give states the ability to repay the debt without any additional cost. For longer-term solutions, however, states may turn elsewhere.
Rather than borrowing from the treasury, a state may choose to solve its unemployment funding crisis through the issue of state bonds. Here, the state raises money by selling bonds that will be paid with interest at a later date. The primary motivation for using bonds is a reduction in interest costs.
Bonds work for states because they are free from federal income tax. Additionally, the repayment of bonds typically takes place over a much greater time period than a loan repayment. It should be kept in mind, however, that bonds always result in the accumulation of interest (whereas treasury loans may be entirely interest free if repaid on time). For a state with a short-term financing problem, the use of bonds may generate greater costs in the long run.
Occasionally, a state will pursue a combination of treasury loans and bonds. As with investment portfolios, utilizing a diversity of borrowing strategies can maximize financial flexibility. At the same time, capitalizing on low and no interest borrowing opportunities can minimize the accumulation of interest.
An example of this would be a state that borrows from the treasury on a short-term basis and issues bonds for the longer term. The loans offer an instant flow of resources, while the money obtained from the sale of bonds can be used to pay off those loans before they accumulate interest. A state may do this in a cyclical fashion and maintain its unemployment benefits in a cost-effective way.