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Unemployment Insurance — Financing — Funding Strategies

Typically, states use one of two primary strategies to fund their unemployment insurance programs. The first, advance funding, relies on the establishment and maintenance of a sizeable fund out of which unemployment benefits can be paid. The second, known as pay-as-you-go, utilizes a system by which employers are called upon to pay into the fund on an as needed basis. Both systems are currently in use, and both have their pros and cons.

Advance Funding

Advance funding, also known as forward funding, is the “standard” way in which states maintain their unemployment insurance accounts. Employers pay a fixed percentage of their payrolls in the form of taxes. When unemployment is low and the economy is strong, the fund grows. When there is an economic recession and unemployment claims go up, the fund is tapped and its balance decreases. This cycle repeats itself and, ideally, the fund is maintained over time.

The obvious advantage to advance funding is that it results in a stable and sizeable unemployment insurance fund. Having such a fund provides for those in need without creating an additional burden on the government or the employers whose taxes finance the fund. It also provides employers with a consistent, predictable tax obligation that can be worked into budget plans.

The challenge, however, is determining the account balance needed to sustain the program in times of high unemployment. Determining this is a complicated, yet inexact, science, relying on factors such as the size of the state economy and the projected need for benefits. Although the balance of an advance funding account is maintained at a higher level, there is no immediate response mechanism when the balances decline to dangerously low levels.

Pay-As-You-Go Funding

Pay-as-you-go funding is exactly as it sounds-employer contributions to the unemployment insurance fund depend on the status of the fund. When unemployment claims rise and the fund diminishes, the required employer contribution increases. States may handle this flexible funding strategy in a couple of ways. First, a state may institute a system of automatic response. Here, if the fund falls below a certain predetermined level, there is an automatic increase in employer taxes or decrease in benefits (or both). Alternately, a state may adjust its system on an ad-hoc basis. This method requires legislative action each time the fund diminishes.

The primary benefit of the pay-as-you-go approach to unemployment insurance funding is that it reduces the large account balances required under advance funding. This means that employers are required to pay lower taxes (except, of course, in times of greater need). This, it can be argued, encourages economic growth and reduces the threat of a recession.

Unfortunately, the very hallmark of this system may also be seen as its downfall. Asking an employer to pay higher taxes during a recession, for example, seems counterintuitive at best. (In fact, it can be argued that such a system calls upon a company to pay for employees it laid off because it could not afford to keep them.) Additionally, decreasing unemployment benefits during a recession can further decrease spending and, as a result, prolong the period of economic weakness.

Copyright 2012 LexisNexis, a division of Reed Elsevier Inc.