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The Federal Unemployment Tax Act (FUTA) establishes two different tax rates on each worker’s first $7,000 US Dollars(USD) of earnings annually. The difference between the two rates is the amount of the credit the federal government grants to employers who file their state unemployment tax returns on time, and whose state unemployment programs meet certain federally-mandated requirements. Payments of federal unemployment taxes may not be deducted from employees’ pay; they must be paid from the employers’ funds. As of 2011, only three states don’t follow this model: Pennsylvania, Alaska and New Jersey. In addition to imposing an unemployment tax on employers, these states also impose one on employees, which employers must deduct from their pay.
FUTA tax rates have remained remarkably stable since the legislation in 1935 and 1939 that set up the American unemployment insurance program. When first enacted, the FUTA tax rate was 0.3% of the first $3,000 USD of each worker’s earnings. FUTA tax rates have increased substantially, but the effective rate, paid by the overwhelming majority of employers, increased only to 0.8%, and was reduced to 0.6% effective in mid-2011. Meanwhile, the earnings subject to FUTA tax rates have increased from $3,000 USD in the 1930s to $7,000 in 1983, with no increases after that date.
The effective FUTA tax rates as a percentage of total income, however, have declined dramatically over the years in relationship to annual earnings. In 1939, when FUTA tax was first collected, fewer than 10% of Americans earned more than $3,000 annually, which meant that the entire income of about 90% of the population was subject to FUTA tax. The current earnings cap of $7,000 was set in 1983, when the average American worker earned more than twice that amount; thus, less than half the national payroll was subject to FUTA.
In 2004, the average annual income had risen to just over $35,000 USD; in that year, then, only about 20% of the national payroll was taxed for FUTA. From another perspective, $56 USD in FUTA tax was paid for every employee in 1983, and by 2010, that amount remained unchanged. After the rate reduction, the annual FUTA tax liability per employee was reduced to $48.
FUTA tax rates can be kept low primarily because unemployment claims aren’t paid by the national Labor Department, which administers unemployment insurance at the national level. Unemployment claims are paid by individual states, each of which maintains its own system. The 1939 FUTA legislation set up an intricate system within which the federal government provides states with the funds to administer their programs, and acts as a source for loans and extensions when circumstances require them. The national Labor Department also sets conditions that states must meet in order to qualify their employers for the 5.4% tax credit.
The states, on the other hand, operate like the famed “50 laboratories of democracy,” with no two having identical programs. Many calculate unemployment tax rates on each employer individually, taking into account the number of claims filed every year. Employers with fewer claims are granted more favorable rates; those with higher claims pay higher tax rates. States generally can dedicate their unemployment tax revenues to paying claims, since their administrative costs are largely underwritten by the national program.