There are a lot of misconceptions about the way the unemployment system works. One topic that is often a source of confusion is the questions of “who exactly pays for unemployment?” Many workers believe that they pay for unemployment through the taxes taken out of their paychecks. That is untrue in the vast majority of states. By and large, unemployment is funded by employers and state governments (sometimes with the assistance of the federal government).

To understand the way the unemployment system is funded, a brief history is helpful. The concept of providing financial assistance to the unemployed gained popularity during the Great Depression as unemployment rates rose to levels previously unseen in American history. The Social Security Act of 1935 contained official provisions for the beginnings of the unemployment system as we know it today. Much has changed about the laws and regulations governing the unemployment system since 1935 however. The unemployment system in the Unites States is a unique state-federal partnership, meaning that the program as a whole is based on federal law, but it is administered at the state level. In this system, states have considerable autonomy to create and enforce their own regulations. This means that unemployment benefits are administered differently in every state, although there are many common trends that can be seen nationwide.

One such trend relates to the financing of the unemployment program. Nationwide, the money that is held in state unemployment trust funds is collected from employers in one of two ways. For private employers, payroll taxes are collected by the state to fund employer unemployment tax accounts from which unemployment claims are paid. This is an experience rated taxing methodology called the “contributory tax payer” system that rewards employers that have good experience with lower tax rates and penalizes employers that have bad experience with higher tax rates.

For public employers, unemployment claims are paid from a state fund, and then employers must reimburse the state dollar for dollar for all benefits paid out. This system is called the “reimbursable or reimbursing” methodology. Non-profit employers and Indian tribes have the option of determining if it’s in their best financial interest to pay through the “contributory tax payer” or the “reimbursable” method. An analysis of what the employer’s tax expenditures would have been in comparison to what their actual charges have been over a 3 year period is helpful in determining the more cost effecting option. Almost universally, it is found that employers with an option, pay less over time utilizing the “reimbursable” methodology. However, when high volumes of unemployment claims are anticipated (layoffs, recessions, etc.) that calculation can change and short term savings can be attained.

Not surprisingly, the employer funded unemployment accounts were not sufficient to pay all of the unemployment claims that were filed in recent years during the Great Recession. Many states borrowed money from the federal government to support the ongoing demand. All but three states (CA, CT and OH) that borrowed federal funds during the last recession have since paid them back in full. There are currently only three states that also tax employees, but only under certain circumstances. Those states are Alaska, New Jersey and Pennsylvania.