Experience Rating and the Dynamics of Financing Unemployment Insurance

The surge of new claims for unemployment insurance (UI) following the COVID-19 pandemic is rapidly depleting states’ UI trust fund reserves. By early July, the trust funds of three of the four largest states (California, New York, and Texas) were already insolvent, requiring them to borrow to cover benefits. We first describe the condition of the states’ trust funds before the start of the pandemic-related recession and examine how the states’ different methods of financing UI were related to those conditions. States that indexed their UI payroll tax base to state average wages had reserves roughly twice those of states that did not index. We then analyze the dynamics of UI trust funds using vector autoregression. Our main finding is that, following a shock to benefit payments and the consequent drop in UI reserves, states’ reserves recover at different rates depending on their method of experience rating tax rates and whether they index their tax base. The trust funds of states using the most common type of UI financing — reserve-ratio experience rating and a fixed tax base — tend to require more than a decade to recover, whereas the trust funds of states using the benefit-ratio method tend to recover within five years whether or not they index. Federal legislation passed in March in response to the pandemic has implications for financing UI that we discuss in light of our findings.