The Pew Charitable Trusts

As the stimulus ends, the clock will start on states paying interest on borrowed unemployment funds

When Pennsylvania officials met earlier this year with business and labor leaders to fix the state's depleted unemployment insurance trust fund, they thought they'd be able to make progress. Since March of 2009, the state has borrowed more than $3 billion from the federal government to continue paying out unemployment benefits. That seemed impossible to sustain. Among the ways to raise money were increasing the wage taxes paid by employers, or simply reducing the level of unemployment benefits to jobless residents.

The talks unraveled. Business groups dropped out of the negotiations, possibly because of a proposed wage tax hike. The state's Department of Labor and Industry is looking into holding new negotiations, this time without that provision, but for now progress on finding a solution is stalled.

The result is that after this coming December, when a provision of the federal economic stimulus law expires , Pennsylvania may have to start paying interest on every federal dollar borrowed. "We'd have to pay the benefits somehow," says Troy Thompson, a spokesman for the state's labor department, "and right now borrowing is the only option." When the federal stimulus dollars run out, depending on the political climate for the remainder of the year, they may never come back. If that's the case, states will incur billions in interest just to keep their unemployment programs going.

There's another incentive for Pennsylvania and dozens of other states that have borrowed federal money for unemployment insurance to pay the debt back. In most of the states, if they don't do so by November of 2011, employers will lose part of a federal tax credit they typically enjoy.

When FDR introduced unemployment insurance in the 1930s to add flexibility during times of widespread joblessness and stagnant spending, he let each state control its own trust fund. What's resulted is the largest set of statewide stimulus programs in the country. But it's possible for the states to seek loans from the federal government to get them over the rough spots. Normally, they can borrow for almost a year interest-free.

Since the current recession began, 31 states have borrowed just under $40 billion from the federal government to fill their depleted unemployment trust funds. It adds up to more borrowing for the programs than ever before, and it's likely to balloon by year's end. If interest rates projected at around 4 to 5 percent were added to that total amount, it would force states to pay an additional $1.6 to $2 billion currently unaccounted for. And that's not the only additional fee that could be imposed. For every year the loans aren't paid back, employers will lose at least 0.3 percent from the federal credit. That could mean that an employer's tax rate of 1.1 percent would inflate to 1.4 percent.

For a state like Alabama, which has borrowed $283 million from the federal government so far, an upward bump in the economy could make repayment on time possible. But for harder-hit California — which is giving out $11 billion in unemployment benefits this year but only taking in $4.6 billion — it's not. California would have to at least double its business tax to make up for the lost $6 billion.

Doug Holmes, the president of UWC Strategies, a business-oriented consulting firm, says 25 of the 31 states borrowing federal dollars will be unable to pay off their loans in time unless Congress acts soon to revise the rules. But this may be an inopportune time for Congress to try to renew the interest-rate moratorium, says Mike Katz, of the National Association of State Workforce Agencies (NASWA). Nothing is likely to be considered before the election, and if Republicans make substantial gains, as is expected, a new stimulus is very unlikely.

According to NASWA, 35 states have already increased the rate of business taxes this year to help alleviate the problem, and seven have raised the portion of employee income per capita that businesses have to pay taxes on. It's not been easy for legislators to convince businesses that raising their employee tax base is a good idea. Florida and Indiana lawmakers voted to raise business taxes last year, only to find themselves pressured into repealing them this year.

Eleven states are currently borrowing in the billions from the federal unemployment relief fund. At over $7 billion, California alone makes up nearly a fifth of the total. Many of the states with large debt can trace that debt not only to the recession itself but to policies made during more prosperous times.

Michigan, a state that has a federal unemployment insurance debt close to $4 billion, provides a striking example. During the last recession in 2002, state lawmakers raised weekly benefits by about 20 percent. Policies like this led the state to unemployment insurance insolvency in 2006, three years before the surge of borrowing among other states began. Because of this, Michigan has already felt the federal penalties that most states are now fearing.

The closest that states have ever come to this level of borrowing happened in 1983, when the recessions of the mid-1970s and early 1980s added up to a collective unemployment insurance debt of $28 billion (the number is adjusted to 2007 dollars). During the first few years of the 1980s, Congress passed a series of reforms that aided the ability of states to pay off the loans. These included increasing federal unemployment taxes on businesses and allowing states to avoid a federal tax credit reduction if they met requirements meant to improve solvency. As that happened, numerous states increased their business taxes and lowered unemployment benefits.

By 1990, all the outstanding debt was paid off, but much of that was aided by a prosperous economic rebound throughout the mid- to late '80s. "If we're going to recover from this period, we need to get lucky," says NASWA Executive Director Rich Hobbie. "That is a steep hill to climb."

Despite all the debt and questions of recovery, Rick McHugh of the National Employment Law Project says it's important to pay attention to the dozen states in good shape. Some are in excellent shape. Washington State hasn't had to borrow from the federal unemployment fund since the 1980s and — if things continue looking the way they are — it won't have to anytime soon. Over the past decade, the state's Legislature and business community agreed to a set of taxes that kept the unemployment trust fund well funded throughout the current recession.

The basic idea behind the Washington State strategy is to pump the trust fund with enough money during the good times so it will be ready for the bad. The Legislature and business community "wanted to create a system that's stable and adequate," says Sheryl Hutchinson, a spokeswoman for Washington's Employment Security Department. "Stability to them is predicting what the future cost will be."

At the end of June, Washington State's trust fund held $2.3 billion, enough to afford 13 more months of unemployment benefits in the wake of the recession. But Washington State's plan to cautiously keep its trust funds full isn't lauded by every economist. Texas, which uses what's close to a "pay-as-you-go" system, could be seen as the polar opposite of Washington State. Rather than pump money into state and federal trust funds, "pay-as-you-go" favors businesses holding onto as much money as possible in good times and cuts benefits and raises taxes during hard times.

Advocates of this approach argue that it allows businesses to make more of an investment in their states. Rather than being shelled up in a trust fund, money flows in a state's economy. But this approach doesn't come without consequences. In the past year, Texas' unemployment insurance borrowing rate skyrocketed to $1.2 billion. And although differences such as the size and major industries of the two states can't be excluded when comparing them, it's also easy to argue one's in much better shape than the other. "Whereas Washington State keeps its business taxes relatively high, it's at a low risk of going insolvent," Hobbie says. "Whether they're in it for the long run is their judgment."