Individual Unemployment Accounts

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The Current Unemployment Insurance Compensation System

The current unemployment insurance system's principal objective is to provide unemployed workers with temporary financial assistance to tide them over while they search for work (Ledvinka and Scarpello 1991). Each state administers its own unemployment insurance program under federal guidelines, but there are substantial similarities in financing and in benefits from state to state. Employers contribute a small percentage of employees' wages, up to a limit, to the insurance fund. An average employer in Michigan, for example, pays an unemployment tax of 2.7 percent of wages, up to the maximum wage base of $9,500 per employee (State of Michigan 2001). (1) However, states can also "experience rate" firms' unemployment taxes. This rating involves raising tax rates on firms that lay off large proportions of their employees and lowering tax rates on firms with stable employment; almost all states use such rating. The current unemployment insurance system is a defined benefit system. Regardless of what is paid into it, states are obligated to pay defined amounts of benefits to eligible workers. Most states also have a minimum and a maximum unemployment benefit. Benefits normally last for twenty-six weeks, unless Congress grants extensions.

A key concept here is the replacement rate, the rate at which unemployment benefits replace earnings. The cap on maximum benefits makes the replacement rate fall with earnings. In Michigan, the unemployment benefit is calculated at 53.3 percent of gross earnings, up to a maximum of $300 per week. Thus, an individual earning $20,000 per year would have a benefit of $205 per week and a replacement rate of 53.3 percent of gross income (72.9 percent of net income) for six months. (2) A person earning $80,000 per year, however, would receive the maximum benefit and have a replacement rate of 19.5 percent of gross income (32.2 percent of net income) for six months. (3) The current unemployment system is designed for persons with a permanent attachment to the labor force. For a worker to be eligible for benefits, the system requires a minimum number of weeks of employment and a minimum amount of earnings prior to becoming unemployed. To be eligible for unemployment benefits in Michigan, an individual normally must have wages of at least $2,000 in the highestearning quarter and total wages of at least 1.5 times the wages of the high quarter during the year that he became unemployed (State of Michigan 2001, 9-13). This provision disqualifies new entrants and reentrants to the labor force. One result of this provision has been a decline in the percentage of unemployed people who receive unemployment insurance benefits--from approximately 50 percent in the 1960s to 35 percent in the 1980s and 1990s (Bruce 1998, 326; Council of Economic Advisors 2003, table B-45; authors' calculations).

The current system is based on at least four assumptions, most of which are now questionable. The first assumption is that unemployment taxes collected during good times should cover the payout costs during bad times. The second assumption is that unemployment is primarily seasonal or frictional (short term), not cyclical or structural (long term). (4) Frictional unemployment consists of people looking for jobs or waiting to take jobs in the near future. Cyclical unemployment arises from recessions, and structural unemployment springs from fundamental changes in industries and the economy. Thus, the current system assumes that the unemployed can find employment in a similar line of work within approximately six months. Career changes and lengthy retraining will be unnecessary. A third assumption is that employees have continuous careers: workers do not leave the labor force (for example, to have children or retrain themselves) except for temporary unemployment and when they retire. The fourth assumption is that the current system's incentive structure will prevent the unemployed and employers from taking unfair advantage of the system. …