Time to Rethink Unemployment Insurance

The Social Security Act of 1935 mandated that the states set up systems for unemployment insurance (UI), and established general guidelines for the operation of those systems. In the middle of the Great Depression, the conventional wisdom held that government alone could solve the problem. Private arrangements to deal with unemployment were swept away.

After more than fifty years of experience with government-run unemployment insurance, it is time to take another look. An increasing number of analysts who have scrutinized unemployment insurance as it now exists have concluded that it creates perverse incentives, wastes resources, and harms our economy's performance.

In brief, here is how UI works in Michigan. Employers must pay a payroll tax based on the wages they pay to their employees. This tax ranges from a minimum of 1 percent of payroll up to a maximum of 10 percent. An individual firm's rate depends on its unemployment experience over the preceding five years. Firms which have had very few layoffs pay low rates; firms which have had relatively many layoffs pay the maximum.

Benefits are paid to workers who have lost their jobs through no fault of their own, provided that they have established enough employment history to show an attachment to the work force. To do that, they have to have earned at least $67 per week in 20 of the preceding 52 weeks. Furthermore, the person must be seeking full-time employment. For those who qualify, their benefits equal 70 percent of their previous after-tax earnings, up to a maximum of $283 per week. Claimants can usually collect benefits for 26 weeks.

Economists have identified inherent shortcomings in the UI system, shortcomings that are pervasive in all 50 states. One is that it actually works to extend the very unemployment it is intended to alleviate by reducing a jobless person's incentive to find new work. As Harvard's Martin Feldstein has written, "For those who are already unemployed, it greatly reduces and often almost eliminates the cost of increasing the period of unemployment." 1

Aggravating the situation in Michigan is the absence of a waiting week. Michigan, in fact, is one of only 11 states that have no waiting period for UI benefits.

Our UI system also requires some firms and workers to subsidize others. Even though a degree of "experience rating" is built into the system, the maximum tax on high unemployment firms falls well short of covering the benefits which are paid to their laid-off workers. Nationally, benefits paid to workers in highly unstable industries such as construction are twice the amount of the taxes paid, whereas benefits paid to workers in more stable industries such as retailing and finance are only half the amount of taxes paid.

But who really bears the burden of UI taxes? To a large extent, the tax is borne by the workers themselves. Wage offers which employers make to workers are made with UI tax costs in mind. Taxes and other employment-related costs are factored in to the total package an employer can afford to offer. UI coverage, therefore, is not at all a "freebie" for the worker.

In effect, then, those workers who seek and hold steady jobs are being compelled to subsidize the unemployment of workers who choose employment which is apt to be sporadic. Many pay steadily throughout their careers, yet never collect even a nickel of benefits. Taxing low-wage but steady-job workers to subsidize high-wage workers who make more frequent use of UI benefits is a common occurrence, and raises basic questions of fairness.

Our present system obviously leaves much to be desired, but people just as clearly want some cushion against the hardship of unemployment. Can we do better?

One possibility might be to convert UI payroll taxes into deposits in Individual Unemployment Accounts (IUAs) similar to Individual Retirement Accounts (IRAs), except that the funds could only be drawn upon in the event of unemployment. Workers could choose to deposit more than the indicated amount if they felt that they needed to build up a bigger cushion. The accounts would be their private property and could be used in any way they desired after retirement, providing an incentive to minimize the duration of unemployment.

A second possibility, which could be combined with the first, would be to completely privatize unemployment insurance. Prior to the socialization of UI in 1935, private policies were struggling to exist but were often forbidden by archaic laws. Professor Michael Rappaport notes, for instance, that Metropolitan Life Insurance Company repeatedly tried to get authority to sell UI from 1919 to 1931 but was blocked each time. 3 There is every reason to believe that private insurers in a free market would offer workers creative, cost-effective options without the disincentives and unfair cross-subsidies of the current system.

More than half a century since the states socialized unemployment insurance, it's time to rethink basic premises and consider creative alternatives. Michigan's legislators--in both Lansing and Washington--should challenge the status quo and champion reforms that would benefit workers and employers alike.