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Unemployment Insurance — Financing — Setting Taxes

The federal-state unemployment insurance program is financed primarily by taxes collected from employers whose employees are protected by the program (and therefore entitled to collect benefits). Typically, these taxes are calculated as a percentage of the employer’s payroll. The percentage, as well as the amount of the payroll taxed, however, may vary.

Experience Rating Statutes

One of the primary variations used by states to calculate an employer’s unemployment insurance tax is known as experience rating. In general terms, experience rating refers to a system by which an employer’s tax is based in part on the frequency its (former or temporarily laid-off) employees collect benefits through the system. This way, employer’s who lay off large numbers of workers or reduce their workforce are contributing more to the unemployment fund than employers who have a more stable workforce are.

A number of states rely on a system of experience rating to determine each employer’s tax obligation. Those that do rely on often-complex formulas and tax charts, tax schedules, and tax capacities. The ideal result is a system that provides sufficient funding for the state’s unemployment benefits program while fairly distributing the burden of funding.

Tax Rates

States who rely on experience rating often have a wide distribution of tax rates. This allows the state to more evenly tax employers. It also allows for much more specific and effective tax responsiveness. The state can more readily target specific categories of employers for increased taxes or tax breaks as needed. It can also adjust an employers tax burden by shifting it from one experience-rating category into another. States have considerable leverage in setting these tax rates ad schedules, although each is required to adhere to a number of federal rules and regulations.

Computation Lag

One of the primary issues facing a state’s tax scheme is timing. In order to set taxes for the upcoming year, a state must analyze its unemployment insurance fund–the current balance of the fund, the state of the economy, and projected benefit payout. With all of these factors in mind, the state must determine how much revenue will be needed to keep the fund solvent. Using this information, combined with individual employers’ experience ratings, the state will set its taxes.

This entire process generally takes place six months prior to the start of the tax year. And since first quarter taxes are not due until the end of April, a total of ten months may pass between the computation date of the tax schedule and the date moneys are put into the state’s unemployment fund. The difficulty arises when the economy changes dramatically during that time. A state may set its tax rates based on a strong economy, but find itself functioning on those payments during a recession. Additionally, an employer who lays off a large number of employees after its taxes are determined will not see a reflection in its tax obligation for a full year.