The Effects of Taxing Unemployment Insurance Benefits Accounting For Induced Labor Supply Responses

Abstract

Taxation of Unemployment Insurance (UI) benefits has been a topic of debate for more than a decade. Arguments for and against taxation revolve around issues of equity, efficiency, and redistributive objectives. The debate bore fruit in 1979 with the passage of legislation which provides for partial taxation of UI benefits. Because the legislation falls short of total taxation and leaves unsettled most of the analytic issues, this paper adds to this debate by presenting new estimates of tax induced changes in total revenues which account for the potential labor force responses to taxation of UI. Estimates of the impact of full taxation are compared to similar estimates for a world in which UI benefits are totally excluded from the tax base (the recent past), and also to the situation which prevails under current law. New information regarding the income replacement function and work disincentive effects of UI under alternative tax schemes is also presented. All of the estimates are based on data from the Survey of Income and Education (SIE). The method of analysis is microsimulation.

This research was supported in part by funds granted to the Institute for Research on Poverty at the University of Wisconsin-Madison by the Department of Health, Education and Welfare pursuant to the provisions of the Economic Opportunity Act of 1964. The authors are grateful to Daniel Hamermesh and Olivia Mitchell for helpful comments.