Policy Documents

Failures of the Unemployment Insurance System

Chris Edwards and George Leef –
June 1, 2011

The Social Security Act of 1935 established the federal-state unemployment insurance (UI) system, which pays benefits to workers who are laid off. Basic UI benefits are funded by payroll taxes on employers, but in recent years Congress has used general federal revenues to fund a range of extra benefits.

With the recent recession and stagnant economy, the cost of the UI system has soared. In 2011, the program will cost taxpayers $134 billion, but the costs are expected to decline in coming years as the economy recovers.1 Note that "unemployment insurance" and "unemployment compensation" are used interchangeably in referring to the system.

This essay describes the origins and structure of the unemployment insurance system. It critiques the justifications given for government-run UI, and it discusses the economic distortions caused by the system. The UI system raises the cost of hiring, creates a disincentive to work, reduces the incentive to save, and subsidizes some businesses and workers at the expense of others.

One reform option would be to switch to a system based on personal UI savings accounts, as the nation of Chile has done. Another option would be for the federal government to fully devolve UI to the state level. If the states financed and administered their own systems, they could more easily pursue innovations to reduce the costs and distortions caused by the current UI structure.