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Incomplete experience rating in state unemployment insurance.

By now it is well established that the existence of unemployment insurance (UI) affects decisions on both the supply and demand sides of the labor market. Theoretical work on such effects has appeared within the past decade, and empirical tests of the basic theoretical propositions have appeared more recently. On the supply side, the tendency of the availability of UI benefits to extend the duration of nominally involuntary unemployment and perhaps to increase labor force participation and improve the success of job search as evidenced by wage gains of job changers has been examined and supported by recent research.

A link between the existence of UI and labor demand has been demonstrated by examination of the system of experience rating--or incomplete experience rating--used to finance benefits in most States. In the United States, States finance UI benefits through a payroll tax on covered employers. In the context of such a financing system, experience rating is the use of payroll tax rates that change inversely with the stability of an employer's labor demand, where that stability is indicated by a measure such as a "reserve ratio"--the employer's accumulated contributions to the system less his accumulated liability in the form of paid-out benefits, with the difference expressed as percentage of his average taxable payroll over some period. Incomplete experience rating limits the allowable tax rates to a relatively narrow range; for example, no State tax rate currently exceeds 10 percent of taxable payroll, and most States have a nonzero minimum rate.

The intuitive argument about the effect of incomplete experience rating on labor demand, or more particularly layoff rates, begins with the realization that many employers assigned either the minimum or the maximum UI payroll tax rate have a zero marginal tax cost of an extra layoff. Those assigned the minimum rate will be contributing to the system regardless of their benefit liability. To the extent that they accumulate reserves beyond those required to maintain their minimum rate assignment, they may have an incentive to draw down the excess through extra layoffs, or "UI holidays." Employers already at the maximum rate cannot be further penalized for additional layoffs; thus, they may also have an incentive to provide UI holidays as part of their contract (implicit or explict) with their workers. Any resulting benefit liability that exceeds their own contributions is paid from the net contributions of other employers (cross-subsidization).

While this connection has been well established theoretically, empirical support has been scarce because of a lack of data. However, the three studies that have been published support the existence of such a relationship. Indeed, the most recent of these finds that the increase in temporary layoff unemployment resulting from the implicit cross-subsidization that incomplete experience rating allows is not only larger but also statistically more significant than the "supply side" unemployment effect of the level of the benefits. The author of that study concludes that, "without chaning benefit levels available to unemployed workers, a significant reduction in layoff unemployment could be achieved by changing the incentives offered by current UI [financing] laws." Moreover, he finds that "the impact of the unemployment insurance subsidy on layoff unemployment is powerful--the imputed subsidy accounts for more than a quarter of all layoffs in the data. . . ." Unfortunately, none of the recent studies considers the incentive that employers assigned the minimum rate have to increase their layoffs, although there is some unpublished evidence suggesting that this effect is small or nonexistent.

The growing body of evidence that incomplete experience rating does increase the amount of layoff unemployment leads one to ask what proportion of employers are subject to the layoff incentives of such cross-subsidization, and, perhaps more importantly, how long particular employers remain at tax rates that allow them to be implicitly subsidized? These issues are important, for persistent subsidization of some employers indicates that the employment stabilization incentives built into the UI system are not working, and it may lead to distortions in the industrial and occupational structure of a State's economy.

To address these questions, I analyzed fiscal 1975-78 UI data for a random sample of more than 17,000 New Jersey employers. The results, presented below, show that, at any time, large proportions of employers are assigned the minimum and maximum tax rates. More importantly, most of these employers have a low probability of moving to any other rate category over time. Indeed, most of them can be assumed to be assigned a limiting rate permanently, thus precluding their effective experience rating. Distribution of employers by rates

Table 1 shows the distribution of employers in the sample by tax rate category for each of the study years. "Graded" employers are firms for which the State had sufficient payroll and turnover information to assign a UI tax rate. The group consists of employers at the minimum rate (1.2 percent of taxable payroll); those at the maximum rate (6.2 percent); and those taxed at one of a range of ra tes in between the two limits. "Other" employers are those to which a rate could not be assigned in the usual manner, either because of inadequate data or their lack of experience in the system. "Inactive accounts" are employers that were not in business during a given year.

Mid-rate employers, the third category of graded units, are the only ones that might be considered truly experience rated, in that their tax rate assignments can respond in either direction to changes in their turnover behavior; all other employers are at least temporarily immune to changes in their payroll tax rate. Given this characterization of the system, the imposition of employment stabilization incentives through experience rating is remarkably incomplete. In each study year, fewer than 41 percent of the active accounts fell into the mid-rate category; moreover, table 1 indicates that only about half of the graded employers could be considered effectively experience-rated.

Because the tax rate reflects an employer's recent history of labor turnover, patterns of experience rating should lag the business cycle by 1 to 2 years. Between 1973 and 1976, business conditions were increasingly recessionary, and thus experience ratings should be rising over the years covered in this study. This is, in fact, the story told by table 1. The proportion of graded employers at the maximum tax rate increased steadily from 8.5 percent in fiscal 1975 to 16.5 percent in fiscal 1978, while the proportion at the minimum rate decreased steadily from 38.0 percent to 32.4 percent. However, there is a surprising regularity in these data for consecutive years, for, while there was a clear shift of proportions from the minimum to the maximum rate as the unemployment rate rose, the proportion of graded employers assigned the middle rates remained at about half throughout the period, regardless of business conditions.

In addition to this consideration of the likelihood of finding an employer on the responsive portion of the tax schedule at a point in time, it is necessary to examine the amount of time employers remain in experience rating categories. An effective experience rating system should induce employers to minimize their labor turnover, and employers paying the maximum tax rate should have a special incentive to avoid such a tax. However, the recent theoretical work on the effects of incomplete experience rating suggests that this is a naive prediction. In particular, theory suggests that employers have very little incentive to avoid the maximum tax rate.

An approach to determining the effectiveness of an experience rating system is to observe the movement of employers among the assignable tax rates. One method of determining this involves the use of Markov analysis.

We know that the movements of employers among tax rates can be described by a transition matrix--in the current context, a 5-by-5 matrix composed of the three graded categories plus "other" and "inactive accounts." Any cell of the matrix indicates the proportion of employers assigned the particular tax category given along the vertical axis who move into a tax category given along the horizontal axis in a particular year. The proportion in each cell is thus a transition probability. Moreover, the transition probabilities found along the diagonal of the matrix represent the proportion of employers who remain in a particular category from one year to the next.

A "simple" Markov model would assume that the movement of employers among the tax rates can be fully described by a single matrix of transition probilities which applies to all employers--in this case, that all employers in a rate assignment category have the same probability of making a given transition to another category between periods. A employers in a given category can be either movers, whose rate assignments follow a regular transition matrix, or stayers, who remain in their category permanently, that is, with a probability of 1. In that case, there are two applicable transition matrixes: a conventional one for movers; and another for stayers, having 1 in the cells along its diagonal and zeros elsewhere.

The importance of determining which of these two processes better describes the movement of employers should be clear. That is, is it reasonable to assume that some employers are permanently either immune to or subject to the employment stabilization incentives of the experience rating system by staying in particular categories of ratings, or is it more accurate to assume that all employers are movers? Evidence that there are stayers in the nonresponsive minimum- and maximum-rate categories and that they represent a large proportion of employers would affect an assessment of the system's degree of experience rating: larger proportions of stayers in nonresponsive categories are evidence of less effective experience rating.

To decide which of the two models is more appropriate for the New Jersey data, I tested the statistical significance of the difference between the proportion of employers who actually remained in a category for the 4-year period and the proportion who would remain in that category if only a simple Markov process of average transition probabilities were operating.

Let d.sub.i represent the difference between the fraction of employers in category i in the the initial period who remain in that category through the terminal year of the data (f.sub.i.) and the expected value of the fraction under the null hypothesis. Thus, d.sub.i = f.sub.i -P.sup.-n.sub.ii where n = the number of transitions in the data (in this case, n = 3); and

= the average probability of staying in a category for one period under the assumption of a Markov process; with w.sub.ii.(t) = the number of employers in category i in period t who are also in category i in period t + 1; and w.sub.i.(t) = the number of employers in category i in period t.

The square of d.sub.i divided by its variance (s.sup.2.sub.di.).sup.11 is distributed x.sup.2 with one degree of freedom. The sum of the ratios for the five categories is distributed X.sup.2 with five degrees of freedom. It is used to test the null hypothesis that there is no significant difference between the number of employers remaining in a category over the 4 years and the number that would remain according to the simple Markov process. If the null hypothesis is rejected, the mover-stayer model is more appropriate.

Following are the ratios of d.sup.2.sub.i to its variance for each assignment category, as well as the summary test statistic for the null hypothesis: Category Ratio value Minimum-rate 100.478 Mid-rate 40.968 Maximum-rate 75.524 "Other" 613.389 "Inactive accounts" 3.824 Total 834.183

The value for "total" leads one to reject the null hypothesis of a simple Markov process at the .005 level of significance. Moreover, the relative values of the category ratios are interesting. Given that a higher ratio implies a more significant deviation of a category's actual stayers from the expected proportion, one should note that the ratios for minimum- and maximum-rated units are much higher than that for mid-rated employers. This suggests that there is a much stronger tendency for the former employers to stay in their categories relative to the Markov process than is found among mid-rated employers. This tendency in these categories which do not impose employment stabilization incentives on employers weakens the effects of experience rating, as does the stronger tendency for mid-rated employers to move out of the responsive part of the tax schedule, as evidenced by their relatively low ratio.

Because the mover-stayer model is more appropriate, I estimated (1) the proportions of stayers (s.sub.1.) in each category and (2) the transition probabilities (m.sub.ij.) of a Markov matrix for movers only. Leo Goodman suggests using the following approximations to maximum likelihood estimators of these parameters when the sample size is large and there are a number of periods of data: s.sub.i = the proportion of employers in experience rating class i in the initial period who remain in that class for the next n periods (n = 3 here); and m.sup.-.sub.ij = the average number of employers in experience rating category i in one period who are in category i in the following period divided by the average number of employers in category i over all periods but the last, for all i and j (both averages calculated after deleting the estimated number of stayer employers from category i).

Estimates of s.sub.i shown below indicate that large proportions of employers stay in their category over time: Assignment category Percent stayers Graded employers at: Minimum rate 55.9 Mid rates 57.1 Maximum rate 66.1 "Other" employers 30.0 "Inactive accounts" 0.0

Among the graded employers, the proportion of stayers is always more than one-half. The important result here is that the proportions of stayers in the minimum- and maximum-rate categories are so high: in particular, almost two-thirds of the maximum-rated employers remain in their category throughout the period. While the virtually permanent assignment of the maximum rate to such a large proportion of employers could be at least partly attributable to factors such as the naturally higher turnover rates of some industries (for example, construction) relative to others (such as banking), it is also consistent with the conclusion that incomplete experience rating actually induces higher layoff rates.

Estimation of the transition matrix for movers (m.sup.-.sub.ij.) indicates that, with the exception of the "inactive accounts" category, movers are more likely to stay in their current category than to move between periods. (See table 2.) Moreover, among the graded employers, the highest such "retention" rate is for the maximum-rate category, where almost two-thirds of the movers remained in the category from period to period. Thus, even for employers designated as movers, transition between categories seems slow, especially among the nonresponsive maximum-rate group. Interpreting the results

The significance of these results is probably best understood in light of some related findings regarding the extent of cross-subsidization in the New Jersey UI system. Available data allow one to estimate the average surplus or deficit per employee-year experienced by each covered employer since its UI account was opened. A surplus position indicates that, on average over the life of the business, an employer has contributed more to the system than his laid-off employees have drawn in benefits; a deficit position indicates that the employer, through laid-off employees, has been receiving a net subsidy from the system. The calculations for the sample of employers studied here show that, as of the end of 1975 and 1976, those assigned the maximum tax rate had net deficit positions per employee-year of $844 and $728, respectively, or about 9 percent of the State's 1975 annual gross wage for a production worker in manufacturing. Taken with the finding that about two-thirds of the employers at this tax rate can be assumed to be "stayers," this suggests that the majority of employers at the maximum rate have been receiving an annual payroll subsidy of about 9 percent of their gross wages. While these calculations are admittedly crude, they do hint at the magnitude of the cross-sudsidization that incomplete experience rating can allow.

These results also help one understand the explanatory power of the minimum and maximum tax rates in layoff equations. Studies by Joseph Becker and Frank Brechling indicate that narrower bounds on assignable tax rates result in a larger proportion of employers being assigned the limiting tax rates. The preceding discussion indicates that, for a given rate schedule, most employers assigned to a limiting tax rate tend to stay there even as business conditions change, and those that move away from such categories do so only very slowly. Thus, a State's maximum and minimum rates represent not only the potential range of responsiveness of its experience rating system but also the potential for actual avoidance of the employment stabilization incentives by a large proportion of employers. Evidence such as Robert Topel's suggests that employers at these limiting rates--especially at the maximum rate--do indeed generate extraordinary turnover rates through their layoffs.

However, the New Jersey results must also be considered in light of the number of employees affected. Because employers at the maximum or minimum rates account for about 20 percent of employment in the sample, the proportion of workers affected by incomplete experience rating is smaller than the proportion of employers--a situation that somewhat mitigates the unemployment effects of the lack of experience rating at the limiting rates. Also, one must keep in mind that different macroeconomic conditions (such as falling unemployment rates) could yield different parameter estimates. For example, conditions of full employment could result in a smaller estimate of the proportion of stayers in the maximum-rate category, although the number of minimum-rate stayers would probably rise.

EVEN SO, THE IMPRESSION left by this discussion of tax rate assignments is that the system analyzed here, which is not atypical, seems to lack strong incentives for employment stabilization, particularly for employers at the maximum rate. Employers tend to sort themselves into tax categories Thus, most employers are either always or never facing the employment stabilization incentives of the UI experience rating system. For employers at the maximum rate, this results in large negative reserves that require subsidization by other employers in the given State's system.
COPYRIGHT 1984 U.S. Bureau of Labor Statistics
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Author:Marks, Denton
Publication:Monthly Labor Review
Date:Nov 1, 1984
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