Heritage Foundation Leadership for America

In the wake of the terrorist attacks on New York City and Washington, D.C., and concern over rising layoffs, policymakers are thinking of reducing payroll taxes to bolster the economy. ¹ One way Congress can lower payroll taxes would be to repeal a little-known temporary surtax on wages and salaries under the Federal Unemployment Tax Act (FUTA), which has outlived its purpose. Repealing the temporary surtax would reduce the cost of employer-paid mandates by $9.5 billion from fiscal year (FY) 2002 to FY 2006, encourage businesses to keep workers on the job, and remove an obstacle to reviving employment growth--particularly among unskilled low-wage workers.

In response to the slowing economy, President George W. Bush has proposed extending unemployment benefits and increasing the funding available for job search, placement assistance, and relocation expenses. ² Even if the surtax is repealed, the permanent part of the FUTA tax would have a surplus of $2.5 billion in FY 2002. Distributing this surplus to the states would help to move the unemployed back into the workforce as quickly as possible and would strengthen the financial condition of the state unemployment insurance benefit trust funds. ³

WHAT IS THE TEMPORARY FUTA SURTAX?

The third-largest tax increase included in the Taxpayer Relief Act of 1997 was the extension of the temporary FUTA surtax, which was scheduled to expire at the end of 1998. Established in 1976 to help restore the depleted federal Unemployment Insurance (UI) trust funds, the surtax was first set to expire in 1987. Since 1987, however, it has been extended five times despite having accomplished its goal in 1988. It is now set to expire on December 31, 2007. ⁴

The revenue from the FUTA tax is designated for the administration of the UI system. The current FUTA tax rate of 0.8 percent on the first $7,000 of wages has two components: a permanent tax rate of 0.6 percent and a temporary surtax of 0.2 percent. Although this payroll tax generated an average of $7.1 billion in revenue per year between FY 1995 and FY 2000, Congress appropriated an average of only $3.6 billion per year for administration of the UI system. 5 The remaining annual surpluses have helped to balloon federal UI trust fund balances from $13.9 billion in FY 1995 to $33.1 billion in FY 2000, and they are expected to jump to $55 billion in FY 2006. ⁶ (See Chart 1.)

The federal UI trust fund balances have become so large that they are expected to exceed their recently increased ceilings by $25 billion over the next five years. ⁷ Over $9.5 billion of this excess revenue comes directly from the temporary FUTA surtax. ⁸ Current federal UI trust fund balances are three times higher than would be necessary in the event of a recession similar to the one that occurred from 1990 to 1991 when the unemployment rate reached 7.8 percent.

To their credit, some Members of Congress have made an effort to eliminate the unnecessary tax, not only because of the burden the FUTA surtax is placing on employers, but also because it is an obstacle to reviving employment growth. Senator Christopher Bond (R-MO) and Representative Donald Manzullo (R-IL) have recently introduced legislation (S. 189 and H.R. 1037) to repeal the FUTA surtax. Together, these two efforts would enable workers and employers to keep $9.5 billion more of their hard-earned money over the next five years. ⁹

WHY THE FUTA SURTAX SHOULD BE ENDED

As Representative Manzullo observed, "The time for small business tax fairness is especially crucial now as we enter a slowdown. Small entrepreneurs traditionally pull us out of the economic doldrums. This legislation gives them the tools to not only weather the storm but to speed up the recovery." ¹⁰

There are three very important reasons why Congress should end the FUTA surtax:

• Ending the surtax would reduce the unnecessary overtaxation of work . Only $3.5 billion (48 percent) of the $7.3 billion FUTA tax collections projected for FY 2002 will be returned in federal grants for the administration of state unemployment offices. ¹¹ Although the permanent FUTA tax is more than sufficient to finance the UI system even in a recession, Congress continues to extend the temporary surtax.

Ending the FUTA surtax would reduce the overtaxation of work by an average of $1.9 billion per year between FY 2002 and FY 2006 and would remove an obstacle to reviving employment growth for unskilled low-wage workers. ¹² Furthermore, eliminating the surtax would not endanger federal UI trust fund balances; its accounts would continue to grow from $44.7 billion in FY 2002 to $55.0 billion in FY 2006--an increase of 23.1 percent.

• Ending the surtax would eliminate inconsistent tax policy . In 1997, Congress increased payroll taxes on American jobs by extending the temporary FUTA surtax to 2007; then it passed two tax credits for employers, the Welfare-to-Work Tax Credit and the Work Opportunity Tax Credit, to lower the cost of hiring unskilled workers.

These conflicting moves--raising taxes on the one hand while reducing them on the other--defy the principles of sound public policy and undermine trust in Congress's stated desire to lower the tax burden on American jobs and jump start the economy. In contrast to Congress's confused efforts, since 1992, 18 states have cut their state UI benefits tax rate to encourage job growth and to control the size of their own UI trust funds. ¹³

• Ending the surtax would help to strengthen state economies . Years of overtaxation have caused an immense amount of money ($38.7 billion in FY 2001) ¹⁴ to pile up in trust funds in Washington. Ending the FUTA surtax would keep tens to hundreds of millions of dollars in state economies instead of transferring that money into ballooning federal trust funds. (See Table 1.) For example, between FY 2002 and FY 2006, ending the surtax would allow workers and employers in South Dakota to keep an additional $26.3 million of their earnings, which they could spend, save, or invest. In Mississippi, workers and employers would see their taxes cut by $83.2 million during that same period. ¹⁵

Ending the FUTA surtax would have even more striking results for the economies of larger states. For example, workers and employers in Illinois would save $435.4 million in taxes from 2002 to 2006; workers in Texas would save $675.6 million; and workers in California would save nearly $1.1 billion. ¹⁶ Keeping more money in the private sector and allowing it to flow into the economies of the states would be far more productive than letting surplus taxes pile up in trust funds in Washington.

DISTRIBUTING FUTA SURPLUSES TO THE STATES

Even if the temporary FUTA surtax is repealed, there will still be a $11.2 billion surplus from the permanent FUTA tax from FY 2002 to FY 2006 ($2.5 billion in FY 2002 alone). ¹⁷ In addition to ending the surtax, Congress should distribute surplus tax revenue back to the states through what are known as "Reed Act" distributions. ¹⁸

Distributing the surplus from the permanent FUTA tax would infuse tens to hundreds of millions of dollars into state UI trust funds and significantly improve the financial condition of those funds and the states' ability to provide UI benefits. (See Table 2.) It would also enable the states to improve their employment services, helping to move the unemployed back into the workforce as quickly as possible. For example, from FY 2002 to FY 2006, Reed Act distributions would amount to $20 million for South Dakota, increasing the state's current UI trust fund balance by almost 44 percent. Mississippi's UI trust fund would receive $62 million, increasing that state's already large UI trust fund balance by over 9 percent. 19

In larger states, the benefits of Reed Act distributions would be even greater. For example, Illinois would receive $405 million from 2002 to 2006, a 23.2 percent increase in its current UI trust fund balance; Texas would receive $730.4 million, a 118 percent increase in its trust fund balance; and California would receive $956.5 million, a 17 percent increase in its trust fund balance. 20

CONCLUSION

It is time to end the "temporary" FUTA surtax (which has been extended five times since 1987 despite record surpluses in the Unemployment Insurance trust fund) and return surplus unemployment taxes to workers and employers. Ending the FUTA surtax would reduce the overtaxation of American jobs and strengthen state economies as, over the next five years, workers and employers could keep $9.5 billion more of their earnings, which they could spend or invest as they see fit.

In 1997, when Congress last extended the FUTA surtax, Members mistakenly thought they would have to increase tax revenues in order to balance the budget. The current economic slowdown and recent terrorist attacks have leaders on both sides of the aisle looking for ways to reduce payroll taxes and remove barriers to employment growth. Ending the FUTA surtax would be a small, but important, step toward lowering the tax burden on American jobs and reestablishing sound and coherent fiscal policy.

D. Mark Wilson is a former Research Fellow in the Thomas A. Roe Institute for Economic Policy Studies at The Heritage Foundation.