Taxation of Unemployment Benefits
By David Henderson
On the comments yesterday on my post on the effect of unemployment benefits on unemployment, Noah Yetter wrote:
You have to pay taxes on unemployement benefits? Am I the only one who finds this to be unalloyed lunacy?
I actually find taxation of unemployment benefits to be “alloyed” sanity. A little background, and I’m summarizing what you can find here.
In 1979, the feds began to tax unemployment benefits for people with more than a certain level of income. To avoid the hundreds of thousands of percent marginal tax rate on one dollar past that threshold that I highlighted about Megan McArdle’s proposal, the feds phased in the taxation. In tax economics jargon, they avoided a “notch” and instead created a “kink.” In the 1982 tax law, the thresholds were lowered and in the 1986 Tax Reform Act, all unemployment benefits became subject to taxation, thus avoiding not only a notch but also a kink.
Why do I find this sensible? For the same reason the Joint Committee on Taxation did: to reduce the incentive that unemployment insurance gives people to remain unemployed. It was Martin Feldstein in the early 1970s, by the way, who popularized this thinking.
My guess is that Noah finds this crazy because he’s implicitly assuming that people who get unemployment insurance are poor or very low-income. Not true. When I was at the Labor Department in 1982, I learned that a large percent of the people who get unemployment benefits are high-income and that for most people who get unemployment benefits, the benefits are substantially less than half of all family income. This is for two reasons. First, most unemployment is short term (although longer-term during recessions and even longer-term during this recession, due, in part, to the length of time for which you can receive benefits.) Second, other family members have income.
Because the Tax Reform Act of 1986 raised the amount of income you could have without paying any tax, someone whose sole income was unemployment benefits and who received such benefits for many months would pay zero or little federal income tax even with unemployment benefits counting toward taxable income.
So why do I say it’s “alloyed” sanity? Because I think we shouldn’t have a government-run unemployment insurance system. Moreover, the term “unemployment insurance” is a misnomer. It’s really a tax-and-subsidy scheme.