Joseph Becker (1992, 1981) emphasized the distortion of relative prices and the consequent cross-subsidization in the UI system when there is less-than-full experience rating. He referred to these problems as inappropriate “cost accounting.” Further, his empirical investigations showed that construction firms tended to be heavily subsidized by other businesses, especially those in finance, the services, and trade. In the long run, this situation must be expected to lead to relatively low output prices, relatively high real wages, and relative overproduction in the subsidized sectors as compared to the operation of perfect markets. For further analysis, see Adams (1986.)
Subsequent empirical work has confirmed Becker’s original research finding of substantial cross-subsidization among firms and industries. The most recent microeconomic empirical analyses of cross-subsidization upon relative e4mployment levels was undertaken by Deere (1991), who concluded that “a 10% increase in the implicit subsidy to a layoff increases the employment share in construction by about 1.7% and decreases the employment share in services by almost 1%.”
The second basic difference between a uniform and an experience rated UI tax relates to the incentives for employers to control layoffs by changing employment practices. Many theoretical aspects of the incentive effects of experience rating have been treated in the literature. Two well-known articles are the ones by Feldstein (1976) and Baily (1978). In addition, Brechling (1977) has presented a model of the incentive effects in the institutional framework of the most common U.S. method of experience rating (that is, the reserve ratio method). This line of research has been continued by Wolcowitz (1984) and Cook (1992).
Briefly, the argument states that since experience rating implies a marginal tax cost for layoffs, a cost-minimizing employer will attempt to adjust layoff practices in response to increases in the degree of experience rating, so as to reduce the level of layoffs, benefit payments, and, hence, employer taxes. The incentive is optimized when there is full experience rating because this would lead to the same level of layoffs that would be generated in perfectly working commodity, capital, and labor markets. This result is especially clear in the Feldstein (1976) model.
The Case against Experience Rating
We are aware of two kinds of counterarguments to the case for experience rating. Since these criticisms have usually been made in comments on papers or in conversation, it is difficult to credit them to particular individuals. Hence, they are presented here without attribution.
1. It is often argued that individual employers do not react to experience rating by altering their layoff patterns. There are two versions of this position. First, the shifting of the tax removes any incentive for firms to control their layoffs, and, second, even with an appropriate incentive, employers are unable to control layoffs. Let us consider these two versions in turn.
The first line of reasoning is that since the burden of the UI tax is likely to be shifted forward via changes in output prices or backward via changes in wages, it cannot have any incentive effects; thus, experience rating cannot be effective in reducing layoffs. This argument is based on the implicit assumption that tax shifting takes place instantaneously, automatically, and at the level of the individual employer. Suppose, for example, that an employer is considering a change in maternity leave policy that, ceteris paribus, would reduce taxes by $X and have a marginal cost of $Y. If the employer would invariably have to pass on the entire net marginal surplus of $(X-Y) to workers in the form of increased wages (and/or to customers in the form of reduced output prices), then the marginal return to the employer would always be zero. Here, tax shifting has been defined in such a narrow fashion that the employer has no inducement to introduce new technology, because any net benefit in the form of higher profits is immediately passed on to others. Thus, there cannot be a profit motive, as economists normally understand that concept.
In contrast to the narrow view of tax shifting, it seems reasonable to assume, as we have done in the illustrative two-industry model, that some industry average of the UI tax is shifted forward or backward and that the behavior of any one employer does not affect the average tax significantly. In this case, individual employers correctly treat their output prices and wages (or compensation packages) as independent of their own attempts to reduce their tax bills; employers can reap, through higher profits, the full net benefits of any changes in layoff patterns that accrue to them through experience rating.
The second version of the argument is based on the assumption that, because employers cannot change their layoff and employment patterns, they have very limited ability to respond to the incentives of experience rating. Hence, experience rating may be unfair for employers who operate in markets with particularly uncertain and volatile conditions.
In our view, the level of incentives of the tax system and degree to which employers can and do respond to these incentives must be determined primarily by empirical investigation, not by theoretical argument. In a very general empirical framework, it is well known that Japanese employment practices lead to substantially lower layoff rates (and unemployment levels) than are customary in the U.S., yet Japanese firms have been well able to compete successfully in international markets. Hence, it would appear that there are some opportunities for U.S. institutional framework has shown repeatedly that employers do react to high marginal tax costs of layoffs by reducing layoffs. The initial findings by Feldstein (1978), Brechling (1981), Clark and summers (1982), and Topel (1983) have been supplemented recently by the research of Card and Levine (1994) and Anderson and Meyer (1994). We, therefore, reject the assertion that, in general, employers cannot control their layoff patterns under an experience rated UI tax structure.
2. It is sometimes argued that experience rating violates the basic principles of insurance and that it should be incomplete or even be replaced by a uniform tax. Our discussion earlier in this section has shown that full experience rating is quite compatible with accepted insurance principles. With experience rating, both employers and employees can be provided with some insurance. Even if experience rating were complete, only employers would lose their coverage, while employees would remain insured.