A Neutral Tax Code Counts Unemployment Compensation as Taxable Income

During the pandemic, implementation issues in some states resulted in underwithholding income tax due on enhanced unemployment benefits, and surprise tax bills, for many jobless workers. For instance, in California, when workers opted to withhold 10 percent of their unemployment compensation for taxes, that only applied to state benefits and not enhanced federal benefits. The American Rescue Plan Act (ARPA) provided relief for workers making under $150,000 by excluding the first $10,200 in unemployment compensation received in 2020 from income taxes.

By the time the temporary exclusion was enacted, more than 55 million tax returns had already been filed. Internal Revenue Service (IRS) Commissioner Chuck Rettig has indicated the IRS may be able to automatically issue refunds associated with the exclusion rather than requiring taxpayers to file amended returns. Taxpayers will need to await final guidance from the IRS on the exclusion.

Since 1987, unemployment compensation benefits have been subject to federal income tax and, in most states, to state income tax. According to the Congressional Research Service, such treatment—including unemployment compensation benefits in taxable income—is common across industrial nations.

The rationale for including unemployment insurance in taxable income is straightforward: the income tax system should treat all compensation types neutrally. Excluding a type of compensation from tax can lead to different effective tax rates across similarly situated households and create a preference for the untaxed compensation. Unemployment insurance is a form of income—similar to a fringe benefit, such as health insurance or tuition assistance—which should be in the tax base like other forms of income.

Prior to 1979, unemployment benefits from the government were not included in the tax base. Unemployment benefits received as part of a private plan, however, were included when they exceeded what an individual contributed. In the Revenue Act of 1979, Congress made taxable a portion of government-provided unemployment benefits for taxpayers making above a certain base level of income. The Joint Committee on Taxation explains the reason for the change because Congress believed

“such benefits are, in substance, a substitute for taxable wages and are equivalent to unemployment benefits paid pursuant to private plans, which are includible in gross income to the extent that they exceed the recipient’s prior contributions. The Congress also believes that the prior total exclusion of unemployment compensation benefits paid under government programs tended to create a work disincentive in that it increased the incentive to remain unemployed, the length of unemployment, and the consequent cost of maintaining unemployment coverage. Thus, for taxpayers with substantial other income during the year, the Act subjects to income tax a portion of unemployment benefits.”

The concern about incentive effects, such as whether unemployment compensation reduces incentives to find a new job, largely came about due to the work of economist Martin Feldstein, who argued that unemployment compensation increased unemployment because it incentivized longer durations and temporary jobs or seasonal patterns of employment. One of his several proposed fixes for the unemployment system was to include unemployment compensation in the income tax base.

In 1981, Congress increased the amount of taxable unemployment compensation by lowering the base level of income for the exclusion, largely to raise revenue for increased duration of benefits. Then in 1986, Congress made unemployment compensation fully taxable, along with other changes to the tax code that reduced marginal tax rates and expanded certain tax credits.

The Congressional Research Service explains that making unemployment benefits taxable “puts all unemployment benefits on an equal basis with wages and other ordinary income with regard to income taxation. Although this action reversed the original policy of taxing UC benefits only above an AGI threshold, it occurred in the context of a law that removed many low-income filers from the tax rolls.” Later changes required states to notify recipients of their tax liability and to provide an option to withhold income taxes from their unemployment compensation.

The American Rescue Plan Act’s exclusion of the first $10,200 in unemployment compensation for certain workers is similar to the one-year exclusion for $2,400 in unemployment compensation enacted in 2009 in the American Reinvestment and Recovery Act. The best argument in favor of the American Rescue Plan Act’s exclusion is the implementation issues in state withholding systems that led to surprise tax bills. Besides two instances of one-year exclusions associated with significant economic downturns, unemployment compensation has been taxable since 1987, and that is the appropriate tax treatment.