David Honigman represents the 15th District in the Michigan Senate. George Leef—an adjunct scholar of the Mackinac Institute—is the Senator’s legislative aide.
Our present unemployment insurance system was established during the New Deal and was certainly a child of its times. The extremely high levels of unemployment during the Depression provided the justification for a governmental takeover of what had previously been a matter of private initiative, namely income maintenance during unemployment. As with many other issues, the assumption at the time was that only the coercive power of the government could solve the problem. Rather than allowing individuals to make the best arrangements for maintaining a stream of income during unemployment, either through their own actions or through voluntary, cooperative efforts, the federal government mandated that the states set up centrally administered programs to provide relief to those out of work.
This approach was very much in keeping with the collectivist philosophy of the era. Unfortunately, it has saddled us with a system that prevents workers from customizing income-security plans for their needs. It is a system rife with inequitable cross-subsidies between workers, and it is inimical to the nation’s economic health. Of all the federal mandates that Congress could repeal, this one should be near the top of the list.
How the System Works
The Social Security Act compels the states to establish unemployment insurance systems. They are given considerable latitude in setting tax rates, benefit levels, eligibility criteria, and so on, but all must follow the same basic design. Employers pay a payroll tax, a certain percentage of each employee’s taxable wage base. In Michigan, for example, employers can pay anywhere from 10 percent to 0.5 percent of a taxable wage base of $9,500. Tax rates vary widely because they are based to a considerable degree on each firm’s “experience rating,” which means the extent to which it has laid workers off and caused benefits to be paid. Even in highly experience-rated systems, however, benefits paid seldom match exactly with employer taxes.
Workers who become unemployed may qualify to receive benefits. To qualify, a worker must have earned at least a certain threshold amount, a means of limiting the system to those workers who have a fairly regular attachment to the labor force. An eligible claimant receives, usually after an administrative delay of several weeks, a check that usually replaces about half of his pre-tax earnings while employed, up to a given maximum. The unemployed worker must certify each week to the administering agency that he is able to and actively seeking work. Ordinarily, the maximum period of time for which benefits are paid is 26 weeks.
Many unemployed people do not, however, qualify for benefits. Those who quit their jobs, were fired for good cause, or did not have enough earnings, to give some common reasons, cannot collect.
The Inequities of the System
Whenever the government levies a tax on business, it creates a problem of tax incidence. That is, who actually bears the burden of the tax? Business taxes are borne by people in their capacities as workers, consumers, and stockholders. Who actually pays the payroll taxes that fund the unemployment insurance system? Mainly, the workers do. Unemployment insurance taxes represent part of the employee’s total compensation package. What employers are willing to offer in wages and other benefits is reduced by the cost of benefits that the government has mandated. If the addition of a worker to the payroll will cost the company $500 in unemployment insurance taxes, that worker will be paid approximately $500 less in cash or other benefits.
Just as the employer’s “contribution” to FICA really comes at the expense of the employee, so is it with unemployment insurance taxes. Although commonly thought of as a free benefit to workers, the system is in reality a means of allocating their income in a way dictated by the state. Because the system is involuntary, however, workers are deprived of the chance to evaluate the benefits of participation in relation to its costs.
For some workers, the unemployment insurance system is a bad deal. There are many who experience little or no unemployment during their careers, yet they pay—in the form of forgone wages or benefits—throughout their working lives for something they may not want or need. For other workers, the system is a good deal. Workers who experience frequent periods of unemployment may receive benefits significantly in excess of their costs. As we mentioned above, experience rating is imperfect, and this means that workers who don’t make much or any use of the system are forced to subsidize those who use it frequently.
This is not necessarily a case of the wealthy subsidizing the poor. Some of those who frequently draw unemployment benefits are high-wage, relatively wealthy workers; some of those who are in stable employment and never collect are low-wage workers. The reverse is also true. The system capriciously redistributes income from stable-employment workers to unstable-employment workers. There is no justification for this coerced redistribution.
The Economic Damage Done by the Unemployment Insurance System
By providing American workers with a safety net in the event of unemployment, albeit one with several holes, the unemployment insurance system discourages that time-honored means of dealing with the possibility of loss of income—saving. People save less than they otherwise would since they believe that the unemployment system will be there to support them in time of need. If people made provisions for the possibility of unemployment by saving, there would be a greater supply of loanable funds, thus tending to lower interest rates and stimulate capital investments. Conversely, the funds accumulated in the system are “invested” by the Treasury in U.S. government debt obligations, which does little—to put it mildly—to help the economy grow.
Not only does the present system discourage saving, it also leads to inefficient use of resources. It does so in several ways. First, it allows employers in businesses characterized by frequent periods of unemployment to externalize some of their labor costs. Seasonal firms, for example, would have to pay their workers more if it weren’t for the fact that the unemployment insurance system subsidizes their operations. Because of this subsidy, we get more seasonal employment than is optimal.
Second, since the system relies on a third-party payor for its benefits, it leads to greater costs than if that third party could be avoided. That is especially true where the third party is a government bureaucracy. We have an extensive unemployment insurance administrative and dispute-resolving bureaucracy. If we moved to a system that avoided much of the third-party involvement, we would save resources for more productive things.
The Voluntary Alternative
What if we allowed workers and employers to handle provisions for unemployment as they think best? How would they react?
Workers differ greatly as to their expectations on the probability of unemployment and the harm it would do them. There is an enormous range from those who are sure that they are set for life in their current employment to those who are rarely sure where the next paycheck will come from. Those in the former category might rationally decide that they don’t want to give up anything in order to have a measure of income security in the event of unemployment. Those in the latter category would, in contrast, regard income security as a high priority.
Whatever their degree of concern over the possibility of unemployment, there are two ways for workers to shield themselves against it. One is saving; the other is risk-pooling (insurance).
Saving is the time-honored means of providing security against the possibility of unemployment or other adverse occurrence. What if we allowed people to set up Individual Unemployment Accounts (IUAs) analogous to IRAs? The individual would decide how much, if anything, to deposit (or have withheld from his paycheck) into the account each pay period. Taxes would be deferred until such time as funds were withdrawn. During periods of unemployment, the worker would decide how much to withdraw from the account. If there were funds in the account at the time the worker retired, he could treat it as an IRA. Given the popularity of IRAs, especially when they were fully tax-deductible, it seems likely that IUAs would catch on very quickly.
We are not fond of the tendency to encourage people to set up savings accounts for particular purposes (retirement accounts, medical savings accounts, our proposed unemployment accounts, etc.). It would be better to repeal the tax code’s bias against saving and just let people save without having to pigeonhole the money. But short of that, IUAs would have several major advantages over the status quo.
First, there would be no involuntary redistribution of income among workers. With each individual saving for himself, the risk of unemployment would no longer be socialized. True, some might be improvident, but that is hardly an adequate reason to force some to subsidize others.
Second, people would have the maximum incentive to find new work after becoming unemployed, since withdrawals from IUAs would be withdrawals of personal wealth. Not all unemployed workers are as diligent as possible when it comes to finding new work now, since the checks come from the government and stop once employment has been re-established. That is, unemployment insurance subsidizes unemployment, and therefore increases its incidence.
Third, the existing bureaucracy would be unnecessary. With IUAs, the decision-making would be individual rather than bureaucratic.
Fourth, as we have already said, an increase in saving would be economically beneficial for the United States.
Risk-pooling is the other means by which people can protect themselves against calamities. People enter into insurance contracts when they choose to pool the risk of losses due to auto accidents, fire, ill-health, and so forth. Could there be a private insurance market for unemployment insurance? In the early years of this century, there were several attempts by major insurance companies to write unemployment insurance, but each time they were thwarted by state insurance regulators who claimed that unemployment was inherently uninsurable. Of course, once the government mandated that everyone have its unemployment coverage, all thoughts of private insurance disappeared.
We see no reason why voluntary risk-pooling for certain types of unemployment could not work. (It is not possible to insure against being fired for cause, since that is within the individual’s will.) People already can insure that their mortgage payments will be made if they should lose their jobs. If the government got out of the unemployment insurance business, private alternatives would swiftly emerge, almost certainly giving workers more flexibility than the current system does.
Workers who had not built up sufficient funds in an IUA to feel that they had enough of a cushion would probably want to buy unemployment insurance, either individually or as an employer-provided benefit. How much insurance to have should be left up to the individual. How much to save should be left up to the individual. We have no idea what combination of insurance and/or saving would be best for people and neither does the government. That’s why it should be left to personal decision.
If we could privatize unemployment insurance, what would we do with the money currently in the trust funds? Given our anal-sis that these taxes are borne by workers, the proper answer is that the money should be returned to them. Michigan’s trust fund is now approximately $1 billion. Although it would certainly not be easy to divide this amount up among current and retired workers based on how much they “paid” into the system, it would not be impossible.
The collectivist approach to unemployment insurance is an anachronism. Abandoning the old system and replacing it with freedom of choice and individual contract would not only be more efficient economically, but would also be consistent with the fundamental American belief that people should be masters of their own lives, not pawns to be moved about at the will of others.
Our conviction is that we would develop a system for unemployment compensation that is both fairer and more beneficial to the economy if we stopped relying on coercion and went back to relying on voluntary cooperation.