Oftentimes a state may offer a reduction in its UI tax rate in order to compete with neighboring states in attracting business. The resulting lost revenue tends to be made up by adjusting the eligibility requirements for many workers. This generally impacts low-wage employees who become disqualified for benefits.

States also find it tempting to reduce UI tax rates during times of economic expansion. The reduced need for funds for UI benefits resulting from an expanding economy becomes a great temptation to lighten the tax load.

Not only is the UI tax a moving target, changing nearly every year, but it can become a bureaucratic nightmare of monthly reporting, subject to the whims of the state and cyclical nature of the economy.

On the other hand, unemployment insurance has acted as a safety net for millions of American workers and their families since its inception by providing temporary wage relief and encouraging re-employment.

Secondly, the UI system helps boost the economy when it is most needed. By allowing for the accumulation of reserves during periods of prosperity, the UI system is able to inject money into the economy during periods of economic decline. This helps boost consumer purchasing power, and, thus, helps mitigate the downturn.

A state function
From its inception, the unemployment insurance system was intended to be primarily administered and funded on the state level. The system is financed almost entirely through a state payroll tax on employers (with provisions for worker payment in just a handful of states).

While the question of who is covered is dictated by the federal government, eligibility and benefit amounts fall primarily under the auspices of the individual state.

But it took deliberate action on the part of the federal government to convince many states of the need for a state-run unemployment insurance program.

Under the Federal Unemployment Tax Act (FUTA), the government established what might be thought of as a "national" unemployment insurance program. FUTA imposed a minimum taxable wage base and tax rate for all designated employers. (Ninety eight percent of all employees work for employers who are required to provide unemployment insurance coverage.)

FUTA required these employers to pay a UI tax of 6.2 percent (later dropped to 6.0 percent) on the minimum wage base of the first $7,000 of salary for all employees.

This tax revenue was deposited into the general Trust Fund. However, the federal government offered to reimburse those employers 5.4 percent of the salary base once the state in which the company did business established its own approved UI program.

This created an obvious incentive for states to create their own programs. Today state-run UI programs can be found in all 50 states, as well as in the District of Columbia, Puerto Rico and the Virgin Islands.

The carrot and the stick
Under FUTA guidelines, state UI programs have developed schedules of tax rates to offer incentives to employers to avoid unnecessary layoffs.

Known as an "Experience Rating," these very detailed and complicated scenarios for determining rates are designed to reward businesses with a low turnover rate, and "punish" those with high turnover rates, by imposing the highest tax rates on employers who generate the most cost to the system.

States have a lot of leeway when it comes to controlling the UI tax rate for their employers.

After these first few years, each state formulates a UI tax rate that is based on the layoff track record of the employer. This track record, or Experience Rating as it is known, determines ultimately what UI tax rate the employer will pay.

The Experience Rating formulas for the state UI tax rates are often very complicated. Most states evaluate their employers by using the Reserve Ratio as an indicator. This formulation measures the ratio of the employer's trust account over the annual taxable payroll. The higher the employer's Reserve Ratio, the better the Experience Rating and the lower the tax rate.

Many other states use a Benefit Ratio for determining an Experience Rating. Under this scenario, an employer pays taxes in proportion to the ratio of the benefits paid relative to taxable wages, regardless of the employer's contribution history.

In addition to the Experience Rating formulation, UI tax rates can also be affected by the trust fund balances themselves. Many states have developed automatic triggering mechanisms so that as the trust fund balance as a percentage of total state payroll moves up or down, so does the tax rate.