Permanent Job Loss

10.Suspension of Experience Rating

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Experience rating is partially or fully suspended in certain circumstances under both the reserve ratio and the benefit ratio methods. In particular, minimum and maximum tax rates are specified by state laws. Changes in charged benefits of not affect these minimum or maximum tax rates, and, as long as an employer is and expects to remain at the minimum or maximum tax rate, changes in charged benefits cannot affect his/her tax bill. The minimum tax rate ensures that all employers make a minimal contribution to the UI system. It is usually regarded as necessary to pay for the no charged benefits that are not attributable to any particular employer. The maximum rate alleviates the tax burden for employers with particularly high past unemployment experiences. At the maximum and minimum rates, benefits are said to be ineffectively charged because they are not allowed to influence employers’ individual tax rates.

Experience rating is also absent for new employers since they have no history of layoffs. Typically, they are assigned an initial fixed tax rate until they acquire the necessary unemployment experience. In some states, this tax rate varies according to the unemployment experience of the industry in which the new employer is located.

Another suspension of experience rating occurs in the case of bankrupt or inactive employers. The costs of unemployment benefits paid to these employers’ laid-off workers may be charged to the employers’ accounts, but since they have ceased to operate, their payrolls and tax liabilities are zero, no matter what their accumulated charged benefits may be.

Trust Fund Solvency
If all unemployment benefits were fully charged and there were no time lags or suspensions in the experience-rating methods, the current tax payments of all employers would be adequate to pay for all current unemployment benefits. If, in addition, a small tax were levied to recover administration costs, then the UI system would be totally self-financed in any particular year. Since the required conditions are not satisfied, however, the UI system may run an annual deficit or surplus. To allow for the carry-over of deficit or surplus balances from one year to another, state trust funds have been established. Employer tax payments (as well as interest and some other disbursements from the federal government) are credited to the state’s trust fund, and unemployment benefit payments are debited.

To ensure the long-run solvency of their trust funds, all states have made provisions for some or all tax rates to rise (fall) as the trust fund balance, expressed as a percentage of the state’s total taxable payroll, falls (rises). These changes in tax schedules are automatic and do not require specific legislation. States differ in the methods by which their tax structures respond to changes in the trust fund balance. In Louisiana, for example, a falling trust fund balance triggers equiproportionate increases in experience-rated tax rates. Thus, with given taxable payrolls, employers with high UI tax rates face larger increases in their tax bills than do employers with low tax rates. In Mississippi, by contrast, a fixed absolute amount is added to all UI tax rates, thus distributing the tax burden equally across employers. As a third illustration, Minnesota raises just the minimum tax rate thus only raising the tax burden of employers with the best experience record. Though the distribution of the extra tax burden may differ among states, all states have made provisions for aggregate tax inflows to increase as the trust fund declines or, indeed, become negative.

In general, state laws governing employer experience rating may be regarded as allocating UI costs to individual employers. Laws governing changes in average tax rates are designed to ensure the solvency of the system as a whole.

While the reserve ratio and the benefit ratio methods of experience rating may be viewed from the perspective of their common dimensions. These two approaches differ in several important respects. We now turn to a description of their unique characteristics.

9. Charged Benefits

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An employer’s unemployment experience is measured by his/her charged benefits (CB) under both the reserve and the benefit ratio methods of experience rating. Charged benefits are the total annual unemployment benefits that have been paid to the employer’s laid-off workers and that have been deemed to be chargeable to the employer’s account. Not all unemployment benefits are chargeable. Examples of no charged benefits are benefits paid to voluntary quitters, some “extended” benefits legislated specifically in particularly severe recessions, and some benefits paid for employee dependents.

Charged benefits arise from both temporary and permanent layoffs. Temporary layoffs are those leading only to relatively short-lived reductions in employment. These cutbacks are reversed by new hires or recalls after fairly brief periods of time. From the perspective of our current discussion, as introduced in chapter 1, the most important characteristic of temporary layoffs is that they of not lead to significant long-run reductions in the taxable payroll. Permanent layoffs, by contrast, are defined as lasting curtailments in the work force and do imply a decrease in the taxable payroll.

It should perhaps be pointed out that the distinction between temporary and permanent layoffs need not necessarily correspond to the unemployment experiences of individual workers. As an example, suppose that worker A is laid off and that worker B is hired as a replacement after a short time. If A remains unemployed for a long period, then the layoff is regarded as temporary by the employer but as permanent by the employee. In this study, layoffs are categorized as temporary or permanent according to the employer’s perception. To be sure, since the rate of recall is typically very high among temporary layoffs, the latter are likely to be perceived as temporary by both the employer and by most of the affected employees.

Our subsequent analysis is facilitated by specifying a temporary layoff rate. Which measures the proportion of the average stock of employees’ layoff in a calendar year? Thus, if the layoff rate is 10 percent and the average level of employment is 450 (as in the preceding example), then the hypothetical employer effects 45 temporary layoffs in the calendar year. Permanent layoffs are measured by the net reduction in the level of employment over the course of the calendar year. In the example, permanent layoffs amount to 100 (i.e., 500-400). Permanent layoffs are zero when the employer adds to employment over the course of the year.

Both temporary and permanent layoffs qualify for unemployment benefits. The weekly benefit payment is determined by state law, usually at about one-half of previous earnings, subject to a maximum. We shall use the concept of benefits per unemployment spell. This is simply the product of the weekly benefit payment and the number of weeks that the laid-off worker receives unemployment compensation. Thus, if the weekly benefit payment is $250 and the duration of the unemployment spell is 12 weeks, the benefit per unemployment spell is (12) ($250) =$3,000. This would be the amount of benefits charged to the employer’s account with respect to each layoff. In practice, the weekly benefit payment and the unemployment duration are likely to differ among employees. Hence, the $3,000 should be considered as an average for all layoffs.

The level of charged benefits can be expressed as the following equation:

The first term in the square brackets in equation represents temporary layoffs, and the second term represents permanent layoffs.

Time Lags

With both types of experience rating, there are substantial periods of time between the year when unemployment benefits are paid and charged to an employer and the year when the tax rate changes. Typically, the employer tax rate for 1994, for example, would have been determined between June and October of 1993, based on the layoff experience over the years 1990, 1991, 1992. These time lags prevent the immediate response of taxes to charged benefits and may cause inequality between a firm’s charged benefits and its tax payments in any particular year Furthermore, neither method allows for interest payments or discounting. Thus, even if the firm pays $100 in taxes for each $100 of charged benefits, the lag of the former behind the latter implies that in present value terms, tax payments fall short of charged benefits.

8. The Two Dominant Methods of Experience Rating

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The UI system in the U.S. has been established under both federal and state laws. The federal statutes lay down general guidelines, under which the states have substantial leeway to fashion systems to suit their own circumstances. Thus, the Federal Unemployment Tax Act (DUTA) mandates that there be experience-rated payroll taxes, but the determination of the exact method of experience rating is left to the individual states. States have enacted various methods of experience rating and, within the same methods, different parameter values. Two forms of experience rating are used predominantly the reserve ratio method (used in 32 states) and the benefit ratio method (used in 15 states). Although these approaches have much in common, their differences may have important implications for the economic incentives they give to employers to alter employment patterns. First, we will review the common characteristics of these approaches.

Common Features of the Two Experience-Rating Methods

The two experience-rating methods share five features. These elements are (1) the computation of the taxable payroll, (2) the concept of charged benefits, (3) time lags, (4) the suspension of experience rating under certain circumstances, and (5) trust fund solvency provisions.

The Taxable Payroll

The firm’s UI tax bill (T) for a particular calendar year is the product of its tax rate (τ) and its taxable payroll (W) for that year. The taxable payroll, in turn, consists of the cumulated earnings of all employees up to the taxable wage base (ŵ) for each employee in each calendar year. On January 1, the process of cumulating earnings starts over again. The minimum taxable wage base is set by FUTA, but higher bases may be mandated by state legislatures. In 1994, the federal taxable wage base was $7,000 and the state bases ranged up to $25,000.

Throughout this book, we assume that the taxable payroll per employee is equal to the taxable wage base and that the employer’s total taxable payroll is the product of the taxable wage base and the mean of the employment levels at the beginning and the end of the year.

Thus, if the taxable wage base is $10,000 and the employer’s work force falls from 500 at the beginning of the calendar year to 400 at the end of the year, the taxable payroll is assumed to be ($10,000) (1/2) (500+400)=$4,500,000.

The preceding approximation of the taxable payroll may be distorted for two reasons. First, employment growth may not be smooth between January 1 and December 31, so that the average employment in the example may not be 450. Second, even if the level of employment does not change during the year, interfirm labor turnover tends to influence the size of the taxable payroll. Suppose, for example, that the taxable wage base is $10,000 and that the annual wage paid in a particular job is $20,000. If the job is filled by one employee for the entire year, then the taxable payroll with respect to this position is $10,000. If, on the other hand, the same job is filled by one employee in the first six months and by a different employee during the second six months, then the taxable payroll is $20,000 because the employer has to cumulate earnings up to $10,000 for each employee. See Brechling (1977) for a general formulation and elaboration of these points and Brechling (1981) for an empirical verification.

Our approximation of the taxable payroll may be stated in equation form:

(8.1) Wt= ŵ

Where Nt represents employment at year-end and Nt-1 represents employment at the beginning of year t. In general, the subscript t refers to a calendar year. The equation relates to the formal analysis that will be developed in later chapters.

7. The Case for Experience Rating

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A comparison of a public UI system with no experience rating (i.e., a uniform tax) with one that is fully experience rated yields two key conclusions. First, unless all employers in the system belong to the same risk class, a uniform tax will lead to a distortion of relative prices and thus the cross-subsidization of unstable by stable activities. As a result, unstable activities are encouraged, and stable ones are discouraged. Full experience rating avoids these problems and generates an allocation of resources similar to that of well-functioning markets. Less-than-full experience rating leads to cross-subsidization.

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.

6. Public Insurance with a Uniform Tax on Employers

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We now assume that, in lieu of the private insurance of the last section, a public UI system is introduced, which is financed by a uniform tax imposed on all employers in both industries. For simplicity, as before, we assume that, due to the UI program, all workers in the unstable industry receive a constant flow of disposable income, including the unemployment benefits when on layoff. Hence, there is no need for self-insurance, and competition equalizes disposable incomes in the two industries.

Suppose that the uniform employer taxis a payroll tax that raises labor costs in both industries by a proportionately equal amount. In comparison with the case of worker’ self-insurance, this increase in labor costs is offset to some degree by the disappearance of the risk premium on earnings in the unstable industry, while there is no offset in the other industry. The stable sector is made to bear some of the costs of the fluctuations in the unstable sector. Consequently, the latter expands relative to the former, and the average instability in the economy increases.
Public insurance with a uniform payroll tax may generate the same two moral hazard problems as private insurance. First, there is the possibility that, while unemployed, workers postpone the acceptance of a job offer because their cost of unemployment is very low or zero. Second, employers have no motivation to enhance employment smoothing: they cannot expect to pay lower wages by offering less job volatility, since all workers currently have complete earnings stability. As in the case of private insurance, both types of moral hazard may by partially avoided by raising worker participation in the insurance.

Continuing our numerical illustrations, a new long-run equilibrium might now have the following characteristics. Let the disposable incomes in both industries be $24,000, of which, in the unstable industry, $1,125 consists of UI benefits. There is a 2.4 percent uniform payroll tax, which amounts to $576 per employee in the stable industry and $549 [=0.024($24,000-$1,125)] per employee in the unstable industry. Hence, the annual marginal cost of an employee is $24,576 (that is, $24,000+$576) in the stable industry and $23 424 (that is, $24,000-$1,125+$549) in the unstable industry. Any administrative cost of the system would raise the payroll tax, but this would not affect the main arguments concerning the effects of a uniform UI tax. As compared with self-insurance by employees, the relative marginal cost of labor falls in the unstable industry and rises in the stable industry; this tends to lead to an expansion of the unstable industry and a contraction of the stable industry.

Public Insurance with an Experience-Rated Payroll Tax

We now allow for an experience-rated UI tax. It differs from the uniform tax in that employers’ tax rates are linked to the claims experience of their own employees.

A concept that may be useful in the following discussion is the degree of experience rating. This measure ranges from zero to full, and then to complete. A zero degree of experience rating corresponds to a uniform tax, which has already been discussed. Complete experience rating is defined as the immediate and total payment by employers of their employees’ UI claims. We define an intermediate degree of experience rating as full experience rating. This exists when each employer is assigned a tax rate appropriate to his/her risk class. A specific risk class consists of employers with similar claims experiences, so that their tax liabilities, when averaged over a sufficiently long period of time, are the same. In the short run, any one employer may have a deficit or a surplus with the other members of the risk class, but, in the long run, all employers pay fully for the UI claims of their own employees.

Two important implications of a public UI system with experience rating are worth emphasizing. First, when there is some degree of experience rating, but it is not complete, this type of UI plan provides insurance to employers as well as to employees. Unemployment benefits serve to smooth employees’ income streams, and the experience rated tax structure tends to generate an even tax flow for employers. It thus serves to smooth also the employers’ cash flows.

Consider again our two-industry example, and suppose that the UI tax is fully experience rated so that employers in the unstable industry pay wholly for the cost of the unemployment benefits over an appropriate period of time. Further, in our illustration, employers in the stable industry pay no UI taxes because their employees never draw unemployment benefits. As in the case of the uniform tax previously discussed. Employees in the unstable industry are assumed to receive a constant flow of disposable income at the same annual rate as employees in the stable industry.

Thus, employees in the unstable industry, when on layoff, receive their full disposable income in the form of unemployment benefits. There is no need for any residual self-insurance by these employees, and the expected annual disposable incomes are the same in both industries. The employers in this industry must now pay, as part of their labor costs, for the unemployment benefits received by their employees plus any administrative costs of the insurance. Full experience rating ensures that UI does not lead to a significant change in the relative marginal costs of labor in the two industries. As with self-insurance and private insurance, but in contrast to public insurance with a uniform, tax, there is no incentive to expand the unstable sector at the expense of the stable sector.

As far as the moral hazard, there is an important difference between, on the one hand, private insurance and public insurance with a uniform tax and, on the other hand, public insurance with an experience-rated tax. This distinction arises from employer incentives to control layoffs. Under an experience-rated tax, employers receive a direct reward, via reduced taxes, for marginally reducing their layoffs. No such direct marginal reward exists under private insurance or public insurance with a uniform tax. Experience rating serves to remove, at least partially, some of the inherent UI inefficiencies due to moral hazard. The other cause of moral hazard, the incentive for the jobless to reject alternative employment offers, remains unaffected.

A numerical example may again be helpful. Suppose that the disposable income in both industries is $25,200. In the stable industry, this consists entrely of earnings, while in the unstable industry; disposable income consists of $22,500 received as earnings from employers plus $2,700 in unemployment benefits. With full experience rating, employers in the unstable industry are subject to an average payroll tax of 12 percent, which is just adequate to raise the $2,700 for the benefits paid to employees. Any costs of administering the system would increase the payroll tax.

5. Self-Insurance by Employees

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In the absence of any type of UI program, a reasonably well-functioning labor market would generate, at least in the long run, higher average earnings in the unstable industry than in the stable one. The absence of earnings during layoffs would be more than offset by high earnings during periods of employment: the average annual earnings in the unstable industry would have to compensate risk-averse employees for the cost and trouble to self-insure against the consequences of layoffs. Competition in the labor market would maintain this earnings differential.

Workers in the unstable industry would have an incentive to control their unemployment duration by accepting any alternative job offers leading to an increase in earnings. Similarly, employers in the unstable industry would have an incentive to control layoffs; if they could reduce layoffs at a sufficiently low marginal cost, they would be able to attract workers from the stable industry at lower annual earnings. Layoff rates, unemployment duration, and earnings would be optimal, giber that risk-averse workers must self-insure against fluctuating income, in the sense that all agents optimize by equating the appropriate marginal costs and benefits.

The allocation of resources between the stable and unstable industries would also tend to be optimal in that the appropriate weight is given to instability and because workers must self-insure. Any exogenous reduction in the degree of volatility would lead to an expansion of the unstable industry relative to the other sector.

For comparison with the cases described in the following sections, let us suppose that the smoothly distributed annual earnings in the stable industry are $25,000, while the fluctuating earnings in the unstable industry are $26,000. The difference of $1,000 represents the cost of self-insurance.

Private Unemployment Insurance

Consider now that there is a private UI program, which can offer a constant annual income stream to workers in the unstable industry at a uniform price per employee that is less than the cost of self-insurance. An insurance company might be able to offer such a relatively cheap contract by pooling the risk of income loss both across individual workers and over time. In practice, the insurance company would have to charge premiums that might be substantial during periods of employment and then return most, but not all, of them as benefits during periods of unemployment. The administrative costs, as well as normal profits for insurance provision, are covered by the difference between total premiums and total benefit payments. Accordingly, we define two income concepts for employees in the unstable industry: gross income is the total average annual income received from the employer, while net or disposable income is the gross income plus total benefits received minus total premiums paid. Movement by workers between the two industries equals the gross income (which is identical to net income) in the stable industry.

In comparison with the case of worker self-insurance, relative labor costs have fallen in the unstable industry, so that there will be a tendency for it to expand. In other words, since risk pooling through insurance has removed part of the undesirable effects of instability, the activity in the unstable industry is likely to expand at the expense of the other.

The introduction of private insurance has given rise to two possible moral hazard problems. First, since the insurance companies pay the full salary as long as individuals remain unemployed, workers have no incentive to accept any new job if they value the leisure time afforded by being unemployed. This “free rider” situation may be avoided partially by proper policing of the insurance contract or by increasing worker participation in the insurance. Clearly, increases in such participation may be obtained through experience rating of individual workers or through benefit payments that decline with the duration of unemployment.

The second type of moral hazard arises from the behavior of employers. Employers have no incentive to increase the degree of employment smoothing because all employees already enjoy even incomes. Hence, personnel would not be prepared to give up income for employment stability. Some degree of worker participation in the insurance may, again, remove part of this moral hazard.

In terms of the previous numerical example, assume that the private insurance industry can offer insurance at a price of $500 a year. A possible long-run equilibrium may then be established by an annual average (gross and net) income of $25,300 in the stable industry and a gross average income of $25,800 in the unstable industry, of which workers pay $500 to insurance companies and retain $25,300 as net average annual income.

4. Experience Rating in Unemployment Insurance

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Unemployment insurance (UI) provides a valuable service. If workers are risk averse because, while unemployed, they cannot borrow against the expectations of future earnings, then they are likely to be willing to pay a premium (possibly in the form of reduced wages) for insurance that mitigates the effects of income fluctuations. These individuals are willing to exchange an uncertain, fluctuating income stream for a certain and constant one with a smaller expected present value see Baily 1977,1978; Stafford 1977; Topel and Welch 1980; Rosen 1983; and Burt less 1990).

In spite of the persuasive arguments for this insurance, private UI markets have been very limited. Many reasons for this apparent market failure have been adduced. For instance, Rosen (1977) and Topel and Welch (1980) ascribe the deficiency to the high concentration of claims during recessions, which inhibits risk pooling among workers. Whatever the reason, all industrialized societies have seen fit to introduce public UI systems. In general, these systems are financed out of general government revenue or by a uniform payroll tax. Only rarely are taxe, imposed on the individual insurants, namely, the workers.

As stated earlier, the UI system in the United States is unique in that it is financed by a payroll tax assessed on and experience rated for individual employers. Thus, employers owe higher taxes when the unemployment benefits paid to their laid-off employees are larger. Details of the two most common methods of experience rating are presented later in this chapter.

Simple Analytical Model of Unemployment Insurance
To illustrate the major consequences of experience rating in unemployment insurance, we postulate a simple model that preserves the essential elements of the various arguments. Assume that there are two competitive industries, which are identical in all relevant respects except that one is stable and one is unstable. The stable industry faces a non fluctuating demand, whereas the unstable industry is subject to recurrent demand swings that may be fairly regular (cyclical or seasonal) or random. Further, within the unstable industry, the demand fluctuations are distributed randomly across individual employers. In the short run, those employers are not affected identically by the variability in industry demand, but over a suitably long period of time, all employers in the unstable industry experience the same average fluctuations. Employers have the ability to mitigate the impact of swings in demand upon layoffs by means of production smoothing and similar techniques, which have marginal costs. Employers balance these costs against the costs of layoffs and rehires and thus determine their optimal layoff rates.

We assume that the total labor supply for the entire economy is not responsive to wage changes (that is, it is perfectly inelastic), although workers can move between the two industries, All worker are assumed to be homogeneous in the relevant characteristics, and, in particular, to have identical degrees of risk aversion, Movements of workers between industries are sufficiently responsive so that, in the long run, the net compensation of employees is equalized in the two sectors. Layoffs are affected by employers, without influence by workers and are distributed randomly across employees. Workers may have the ability to control the duration of unemployment, however, by accepting or rejecting new job offers. All of these assumptions can be relaxed without affecting the essential results of the following arguments.

We analyze this simple model under four different sets of circumstances. First, there is no formal UI system, so that employees must self-insure. This means that workers in the unstable industry must provide for their own income maintenance during periods of unemployment, by saving and/or borrowing. Second, there is private UI financed by premiums charged to individual workers. Third, there is public UI financed by a uniform employer tax. For the sake of simplicity, we assume that all UI programs are complete, in the sense that they smooth out completely the income fluctuations caused by layoffs.

3. Principles of Insurance and the Current Structure of U.S. Unemployment Insurance Financing

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In this chapter, we sketch the background to the central analysis presented in the remainder of the book. First, we discuss briefly the major principles of insurance and the manner in which experience ration operates. Second, systems of unemployment insurance (UI) without and with experience ration are outlined and analyzed. Third, the two chief experience-rating methods currently used in the U.S. are described. We then briefly review some of the relevant recent theoretical literature on experience rating.

Some Basic Principles of Insurance

Insurance is a contract in which an individual pays premiums to an insurer, who promises to compensate the insurant for a loss caused by some unpredictable circumstance covered by the agreement. Thus, insurance is a hedge against the costs of uncertain events. Risk aversion on the part of the insurant and the ability of the insurer to pool risks make insurance possible, likely, and generally efficient from an economic perspective.

Insurance may, however, entail some inefficiencies. Most notably, the so-called moral hazard problem arises when the insurant has some control over the insured event. For example, an insured business owner facing bankruptcy might hire an arsonist; if the owner could easily arrange for the burning of the business, insurers would be unwilling to provide insurance. Thus, for private insurance markets to exist, the insurer must be able to control moral hazard at a low cost.

In well- functioning insurance markets, the price of insurance, namely, the premium, is set at a level such that the present value of the stream of the insurant’s premiums is just equal to the expected present value of the individual’s insurance claims plus the cost of administering the contract, all measured over an appropriately long period of time. Insurants with similar risks of loss are grouped together into a risk class and are charged the same insurance premium. Thus, within a risk class, insurance claims and premiums tend to offset one another, both over time and across different insurants. In other words, risks are pooled both over time and among different members of the same risk class. As a consequence, over an appropriate span of time, the members of the risk class finance their own claims, producing neither a surplus nor a deficit. In any particular year, any member of the risk class may, of course, have a deficit or a surplus with the pool.

It follows that an insurant’s weekly, monthly, or annual insurance premiums will differ according to the risk class to which that individual is assigned. For example, teenagers pay higher automobile insurance premiums than do adults, house insurance is more expensive for dwellings located near frequent mud slides or in a hurricane area, life insurance is more expensive for people with severe medical conditions, and so on.

In some types of insurance, in which the insured event occurs repeatedly, the insurant may b reassigned periodically to a different risk class, depending on the person’s prior claims experience. This procedure is caked experience rating, and it is particularly helpful when the factors, such as age, sex, and marital status, are not very accurate predictors of the insurant’s risk class. Thus, if an insurant’s claims were very low over a period of years, the individual may be assigned to a lower risk class with a decreased premium. Perhaps the best known example of experience rating occurs in automobile insurance in the form of “good driver discounts.” Experience rating may also be affected through a special levy, such as deductibles or copayments, when an insurance claim is paid.

Two related aspects of experience rating are of special interest. First, experience rating implies incentives for the insurant to reduce claims by either controlling the uncertain events or by not submitting claims. Experience rating in automobile insurance may induce insurants to drive more carefully and/or to pay for minor accidental damage out of their own pockets, so as not to lose the “no claims bonus.” In this way, experience rating tends to reduce the various forms of moral hazard in insurance.

Second, experience rating implies that there is participation by the insurant in the insurance against the occurrence of the uncertain event. This is the coinsurance aspect of experience rating. The extent of this participation depends upon the degree of experience rating. As the degree of experience rating increases, the insurant’s premium (or copayment) corresponds more and more closely to his/her recent claims experience, so that the insurant pays more of the bill out-of-pocket.

Suppose, for instance, that the insurant has a claim for $5,000 and that consequently this individual’s premium either shows no change or rises immediately by $500 or $5,000. If the premium does not increase, there is no experience rating. If it rises by $5,000, experience rating is extreme in that the insurant suffers the entire loss. Since the total insurance premium includes a charge for administrative expenses, the insurant will reject contracts with such severe experience rating conditions: they impose costs (the $5,000 plus administrative fees) yet offer no insurance protection.

Experience rating appears to be particularly effective in discouraging relatively small and frequent claims against which insurants are quite willing to self-insure. Further, since these types of claims tend to have especially high administrative costs, their elimination is likely to reduce average insurance premiums.

2. Study Results

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Our work has produced a number of findings. First, permanent employment reductions amount to about 70 percent of total employment reductions. While employment reductions are not necessarily the same as layoffs, our evidence, using UI data for Texas for 1078-8, together with some previous results, indicates that permanent layoffs are a significant proportion of total layoffs. Thus, our analysis of experience rating in the context of permanent layoffs seems justified.

Second, based on our theoretical model, the socially optimal rate of moving labor from contracting to expanding sectors can be achieved only when the transfer costs are borne either by the laid-off employee or by the employer in the contracting industry. The agent who pays for the transfer costs must also control the rate of transfer of labor.

Wages and prices adjust to different payment mechanisms to bring about the same socially optimal rate of labor transfer. Even if wages are not fully flexible, the socially optimal rare of transfer may still be achieved by charging the costs to the employer in the contracting sector. Furthermore, under the current system, laid-off workers are paid UI benefits on the condition that they actively search for alternative employment. Although this requirement is enforced with varying vigor in the states, it is designed to ensure that workers are, indeed, transferred to the expanding sectors at 3 socially optimal rate.

When the agent who pays for the adjustment costs does not control the rate of layoffs or hiring, there tends to be a large, non optimal adjustment of labor, or high structural unemployment. Since the government is usually not able to control the rate of transfer of labor, payment of the adjustment costs by the government (financed, for example, from general revenues) is non optimal. It may be argued that government financing is justified, to the extent that markets bring about too slow an adjustment. However, we conclude that, in general, experience rating (charging the costs of unemployment back to the contracting employers) generates socially beneficial results. This conclusion reinforces the finding that, with only temporary layoffs, increases in the degree of experience rating tend to lead to improvements in the allocation of resources.

Third, when layoffs are permanent, payroll taxes are not an ideal way of implementing experience rating. Temporary layoffs leave the taxable payroll (that is, the tax base) more or less unchanged, while permanent layoffs reduce the taxable payroll. Suppose, for example, that a firm’s layoffs increase and that the UI benefits received by the laid-off workers are charged to the firm’s account. If the layoffs are temporary, the taxable payroll remains more or less constant, and tax payments increase after a lag. If, by contrast, the layoffs are permanent, the taxable payroll and, hence, the firm’s tax payments fall immediately. After a lag, the firm’s tax rate and tax payments may rise to reimburse partially the UI system. In the limiting case, when the firm goes out of business, its taxable payroll and tax liabilities fall to zero. Thus, the charged benefits can never be recovered.

Our analysis shows that, under both systems of experience rating, UI tax liabilities are less than the benefit costs of permanent layoffs. In particular, when the firm is and remains at the maximum or minimum tax rate, it receives a tax reward for laying off workers permanently. This is the very opposite result to that intended by experience rating.

When the firm’s long-run position is on the experience-rated portion of the tax schedule and the maximum tax rate applies only temporarily, then the reserve ratio method of experience rating, because of its longer memory, tends to generate a higher ratio of taxes to benefit costs than is true with the benefit ratio method. In other words, the reserve ratio method tends to internalize a higher proportion of benefit costs than is true with the benefit ratio method.

We conclude this book with suggested economic policy changes. These recommendations are designed to increase the degree of internalization of the costs of unemployment. Some of our policy suggestions have been made before: increasing or abolishing the maximum and minimum tax rates and shortening the lag between benefit charges and tax increases would improve the performance of the systems.

Our relatively new policy suggestions refer to the reserve ratio method of experience rating. First, positive balances in the UI trust fund should be treated as part of the employer’s assets, and negative balances should be considered as liabilities. Second, upon bankruptcy, the firm’s positive or negative balance in the UI trust fund should be counted as part of business assets or liabilities. Moreover, the UI trust fund ought to be allowed to claim reimbursement for part or all of the firm’s UI liabilities in bankruptcy proceedings. Third, interest should be paid to the firm on its positive balances and charged on its negative balances. Together with the abolition of the maximum and minimum tax rates, these provisions could ensure the complete internalization of the costs of permanent as well as of temporary layoffs.

Much of the analysis underlying this study is abstract and mathematical. In our exposition we have attempted to present the arguments and principal findings first in intuitive terms and then more formally. We hope that this structure, which inevitably leads to some duplication, makes the research meaningful to a larger readership than would be the case with a tight mathematical presentation.

1. Introduction and Summary

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The U.S. unemployment insurance (UI) system is unique in the world in that it is financed by an experience-rated payroll tax. This means that individual firms pay higher or lower UI taxes depending on whether they cause more or less unemployment__and unemployment benefit payments. Experience rating internalizes the costs of unemployment to individual firms, thereby inducing them to stabilize employment patterns. Hence, experience rating may lead to a reduction in layoffs and in unemployment.

Since the inception of the federal-state UI system in the mid-1930s, the experience-rating provisions have been vigorously debated among politicians, trade unionists, business people, and academic economists. The last comprehensive treatment of all aspects of experience rating was undertaken by Joseph M. Becker, whose seminal book on this topic was published in 1972. His views were restated, with minor modifications, in his 1981 monograph. Becker’s work was followed by the contributions of Feldstein (1976), Brechling (1977), and Baily (1978). The early literature was surveyed by Hamermesh (1977, 1978), Gustman (1982), and Topel and Welch (1980).

The Need for Research

In the research underlying this book.We havereexam-ined the role of experience rating in the UI system. Such reconsideration is needed because of recent changes in labor market conditions, including the growth in permanent employment reductions due to major downsizing by some large employers, increased numbers of plant closures, and bankruptcies. Large structural shifts in economic activity and employment took place in the 1980s, and they are likely to continue. Thus, the question arises as to whether the present UI system and, in particular, its experience-rating provisions are capable of coping adequately with the consequences of the substantial reallocation of labor. Our research is aimed at providing some answers to this important economic and political question.

Current systems of experience rating seem to be well designed to allocate the costs of unemployment caused by temporary, easily predictable, and recurrent layoffs. Such layoffs do not lead to significant permanent employment changes. There are valid arguments for allocating the costs of temporary layoffs to the firms that caused them. Further, in most states, it seems that the existing experience-rating systems can be modified to allocate these costs to the appropriate firms.

Most theoretical and empirical investigations of the UI system have been based on models of temporary layoffs. For instance, the influential article by Feldstein (1976) and later contributions by Wolcowitz (1984) and Cook (1992), all employ an approach, similar to that of early implicit contract theories, in which employees have a lasting attachment to a particular firm, but are laid off periodically and later recalled in a fairly predictable manner. In these models, UI benefits are a means of raising workers’ incomes during periods of temporary unemployment, and, so the argument goes, these benefits ought to be regarded as part of the firm’s labor costs. If, by contrast, UI benefits were financed by a general payroll (or other) tax not based on an experience rating, there might be more layoffs, and high-layoff firms would receive a permanent subsidy from low-layoff firms. As a result, high layoff activities would be expanded. Experience rating clearly leads to increased efficiency and social well-being, at least from a long-run perspective.

In much of the UI research, experience rating is modeled in a fairly abstract manner. For example, following Feldstein’s original contribution, many researchers have described experience rating simply by the ratio of total benefits charged to the tax payments of employers. The reserve ratio method of experience rating, which is the most commonly used approach, has been modeled by Brechling (1997) and, more recently, by Wolcowitz (1984) and Cook (1992). Cook has extended the work to the benefit ratio method, the other important technique of experience rating. Both approaches imply that experience rating is imperfect in the sense that (1) there are substantial lags between the payments of benefits to workers and the corresponding receipt of UI taxes, and (2) there are maximum and minimum tax rates that curtail or even suspend the relationship between benefits and taxes. Although these features of the UI tax systems have been modeled in an insightful manner by both Wolcowitz and Cook, neither examines the effects of permanent employment reductions.

Suppose now that a substantial proportion of total layoffs is permanent, necessitated by some structural development, such as changes in tasted, new technologies, or competition from imports. Some plants may have to close completely, some may go into bankruptcy, and others may experience substantial downsizing. In any case, employment in the industry must contract substantially. From a social point of view, who should bear the unemployment costs of these layoffs? Is experience rating a desirable property of the UI system? So present experience-rating methods allocate these costs appropriately? These types of questions have not been considered in the previous literature on experience rating. Consequently, we have addressed these issues in our research for this book.