Full text of Economic Review (Federal Reserve Bank of Kansas City) : June 1976

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JUNE 1976

Federal Taxation of
Financial Institutions ... .. .. .. .. . . .. page 3
Unemployment Insurance
Part II: Programs and Problems . . .. .. page 16

•

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Federal Taxation of
Financial Institutions

By Margaret E. Bedford
axation of financial institutions promises
to be a major topic of discussion this year
and next as Congress considers a number of tax
reforms and proposals to restructure the
nation's financial system. Proposals to reduce
or eliminate various tax shelters are likely to
receive particular attention in view of the
continuing large deficits of the U.S. Treasury.
Financial institutions like other tax-paying
groups can benefit from legalized tax shelters.
Some of the tax shelters utilized by financial
institutions include the exclusion from taxable
income of interest on state and local securities,
deductions for bad debt or loan loss reserves,
and tax credits to reduce total tax liabilities
such as the investment and foreign tax credits.
Tax reform also is likely to be of considerable
interest within the financial community itself,
particularly for those depository institutions
that feel they bear a high tax burden relative to
other depository institutions. In the early
I 960's. for example, commercial banks argued
for tax reform since their income taxes
averaged 34 per cent of net income while most
thrift institutions paid little or no Federal

Monthly Review • June 1976

income taxes. 1 Since 1962, however,
commercial banks have reduced their effective
tax rates substantially. In contrast, the tax
burden of thrift institutions has risen sharply.
Consequently, thrift groups recently have been
critical of the current tax laws.
This article examines the upward trend in
the Federal income tax burden of savings and
loan associations and mutual savings banks
since 1962. The article also discusses the major
I Throughout this article , the tax burden , or effective tax
rate , of financial institutions is measured by dividing
Federal income taxes by net income which is equivalent to
profits before taxes. It is not taxable income, but rather
includes such items as interest earned on state and local
government obligations, net long-term capital gains, etc.
Possible biases may occ ur in these ratios due to the timing
of gains or losses, changes in depreciation methods ,
differences in amounts of tax liabilities actually paid and
tax estimates reported to financial regulatory agencies , etc .,
but the relationships of these rati os among groups of
institutions are not likely to be altered. Ratios for
commercial banks and mutual savings banks were
computed from call a nd income report data reported to the
F.D.I.C. by in sured instit utions . Ratios for savings and
loan associations were computed from figures published by
the Federal Home Loan Bank Board in Combined
Finan cial Statements.

Federal Taxation of

tax shelters utilized by these institutions. The
use of tax shelters b y commercial banks and
the resulting drop in their Federal income tax
burden was examined in a previous article in
this Review. 2 Finally, the tax burdens of thrift
institutions and commercial banks are
compared and reasons are given for differences
in their tax burdens.
FEDERAL INCOME TAXATION OF
THRIFT INSTITUTIONS
Savings and loan associations and mutual
savings banks first became subject to the
Federal corporate income tax laws in 1952. In
general, the base for taxable corporate income
rep rese nts incom e from operating transactions ,
such as interest on loa ns a nd sec urities, etc . ,
less allowable ope rati ng expe nses, such as
salaries, wages, and interest paid on savings
accounts, etc. This figure is then adjusted to
make allowance for net loan losses or
recoveries , net securities gains or losses , loss
carryover and carryback provisions, and other
modifications to income. Special tax provisions
applying to thrift inst itution s were also
instituted in 1952. The most notable of the
special provisions were the treatment of gains
and losses on securities transactions-which
also applied to commercial banks-and the
treatment of additions to bad debt reserves for
losses on loans.
Federal Tax Burden
Although thrift institutions became subject
to Federal corporate income tax laws in 1952,
their actual tax burden was quite small over the
next decade. (See Chart 1. ) Contributing to
th eir mod est tax burden were the liberal
provisions regarding transfers to bad debt
reserves . Specifically, thrift institutions were
not subject to a tax li abi li ty on additio ns to bad
debt rese rves until th ese rese rve funds reached
2 See M argare t E . B e d fo rd , " Inc o me T axa ti o n of
Commercial Bank s," M onthly R eview. Fed e ral Reserve
Bank of Kansas Ci ty, J ul y- August 19 75, pp . 3-11.

12 per cent of their total savings account
balances. Reflecting these provisions, insured
savings and loan associations in 1962 paid out
only $3.1 million in Federal taxes, or 0.4 per
cent of net income , while maintaining reserves
and undivided profits of $6.1 billion. Insured
mutual savings banks in 1962 paid $0.5
million, or 0.2 per cent of net income, in
Federal income taxes and carried reserves,
surplus , and undivided profits accounts of $3.3
billion.
Realizi ng that allowable tax-free transfers to
reserves were unnecessarily large, Congress
revised the tax laws under the Reven ue Act of
1962. As a result, taxes paid by sav in gs and
loan associations rose to $93 .1 million in 1963
and their tax burden rose sha rpl y to 12. 2 per
cent. The effective tax rate paid by mutual
savings banks showed a much milder in crease
to 2.0 per cent as their tax payments rose to
$3.4 million. Corporate tax rates were reduced
in 1963, but no other major tax changes
affecting thrift institutions occurred between
1963 and 1968. During this period, though, the
tax burdens for both savings and loan
associations and mutu a l savings banks rose
mode rately.
Under the Revenu e Act of 1969, substantial
revisions were mad e in the tax laws governi ng
financial institution s. These revisions included
changes in the treatme nt of net long-term
cap ital gains, provisions to further restrict
additions to bad debt reserves. and the
app licat ion of a minimum tax on those
additions as well as on other items of
preference income. A su rtax also was levied on
all taxabl e income in 1968, 1969, and the first
half of 1970, and tax rates on net long-term
capital gains on secunt1es were raised
beginning in 1969. The Ta x Reduction Act of
1975 lowe red corporate tax rates on in come less
th an $50.000 for 1975 and 1976 .
As a res ult of th e 1969 changes in the tax
st ructure. thrift institutio n s ex perienc ed a
signi fi cant increase in their tax b urd ens. T he
FedPral Reserve Bank of Kansas C ty

Financial Institutions

Chart 1
FEDERAL INCOME TAXES AS A PER CENT OF NET INCOME

Per Cent
Per Cent
45.0 - - - - - - - - - - - - - - - - -- - - - - - - - - - -- - - - - - 45.0

40.0

35.0

30.0

25.0

20.0

','~-----

Insured Savings and Loan Associations

15.0

','" __ ,
',,...

,,,---'

~--~....
\

, .... ----___.,.,,. Savings Banks

o~~!'!!!!!!!!!!!!!~!!!!!!!'!"!!!!~~---....-..i!!!!~-- - - --

15.0

,/\
.,,/ Insured Mutual

10.0
5.0

;';'

20.0

- -- - -----1

10.0
5.0

-5.0 .__...__-.._.....___.,_.__...__~.....,____._____._....___ __.________._____.__....__ _.._______ -5.0
1
1
1
1
1952 '54 '56
58
60 '62
64 '66
68 '70 '72 '74
effecti ve tax rate for savings and loan
associations rose from 14.4 per cent in 1968 to
24 .8 per ce nt in 1974, and the tax burden of
mutu a l savings banks increased from 3.3 per
cent to 16. 9 per cent over the same period .
However , t he decline in corporate tax rates in
1975 resulted in a slight reduction in tax
burdens. The effective tax rate for savings and
loan associations in 1975 was 24.0 per cent and
for mutu a l savings banks 12.4 per cent. In
1975, savings a nd loa n associations paid $0. 5
billion in Federal taxes and mutuals paid $67
million . Wit h the erosion of traditional tax
shelters and the rise in effective tax rates, thrift
in stituti ons sought new aven ues of red ucing
taxable in come and holding down their rising
ta x bu rd e ns .
Month y Review • June 1976

TAX SH EL TEAS OF
THRIFT INSTITUTIONS
Tax shelters are legal methods of using tax
accounting rules or intended tax incentives to
obtain an immediate reduction in tax
payments. Financial institutions use a number
of these methods to reduce their tax liabilities.
Tax benefits result from sheltering income
through tax-free additions to reserves for future
losses on loans, earning interest on tax-exempt
municipal sec urities, and managing capital
gains and losses to obtain maximum tax
advantages. Tax red uct ions can also be realized
by deferring tax payments to future periods
through
such
methods
as
accelerated
5

Federal Taxation of

Table 1
SELECTED TAX ADVANTAGES FOR MAJOR FINANCIAL INSTITUTIONS, 1973

Deductions
Fro m Income

Esti mat ed+
In
Thousands Increase in Tax
Burden
Without
of
Tax Provisio n
Dollars
(Per Cent)

Interest on state and local securities

Savings and loa n associations
Mutua l savings banks
Commercial banks
Bad debt losses on loans *
Savings and loa n associat io ns
Mutual savings ban ks
Commercial banks

Mu t ual savi n s banks
Co mmercial banks

Estimated+
In
Thousands Increase in Ta x
Burden
Without
of
Ta x Provision
Dollars
(Per Cent)

Investment tax credit

16,892

0.3

52,982

3.3

3,862,232

20.8

699,456

12.6

155,45 1

9.7

Sav ings and loan associations
Mutual savings banks

856,908

4 .6

Comm erci al banks

Gross de preciation t

Savings an d loan associa ti o ns

Credits or
Ad ditional Taxes

Savings and loan associat ions
Mutual sav ings banks
Commercial banks
Foreign tax credit

4,992

0.2

2,083

0.3

99,616

1. 1

0.0

343,809

3.9
- 1.7

Minimum tax on preference items

166,918

3.0

Savings and loan associa tio ns

44 ,47 9

61,429

3.8

Mu tual sa vings ba nks

19,267

2.5

1,681,793

9.0

Co mm ercia l bank s

9, 087

0.1

* Bad debts for savings and loan associations and mutual savings banks were estimated from changes in
reserve accounts and thus may reflect changes in reserves for reasons other than transfers to loan loss
reserves .
tDepreciat ion deductions cannot be separated between normal depreciation for ordinary bank assets and
accelerated depreciation nor can depreciation on leased assets be determined.
tThe calculation of the percentage i ncrease in taxes assumes a marginal tax rate of 48 per cent applicable
to all institutions. Insofar as some banks would have been subject to lower tax rates , the tax benefits
shown would be overestimates .

depreciation . In addition, tax payments may be
reduced by utilizing tax credits such as the
in vestment and foreign tax credits. Such credits
result in a dollar-for-dollar reduction in taxes
si nce they are deducted directly from the
amount of tax payable , rather than from net
income before the tax rate is applied.
The relative importance of several tax
shelters to financial institutions in 1973 is
shown in Table 1. As can be seen , thrift
institutions realized the largest tax benefits
from transfers to bad debt reserves, while
commercial banks utilized tax-free interest on
municipal securities as their major tax shelter.
Gross depreciation resulted in a significant tax
savi ng for all finan cial institutions , but the
amount of sheitered income is not as large as
the figures shown. Depreciation cannot be
se parated betwee n that on assets used directly
6

in bank operations and that on leased assets
nor can the amount of accelerated depreciation
be ascertained from the available data.
Depreciation on regular plant and equipment is
an expe nse of doing business, while accelerated
deprec iation and depreciation rea li zed through
leasing operations reflect , at least in part, a tax
shelter. The tax benefits from the investment
and foreign tax credits were very small for thrift
institutions but represented significant savings
for commercial banks.
Transfers to Bad Debt Reserves. Thrift
in stit uti ons, as well as other taxpayers, are
allowed a deduction for bad debts in arriving at
taxab le income. This deduction may be
calculated under the specific charge-off method
or on the reserve method. The specific
charge-off method allows institutions to deduct
actual losses from, or add recoveries to, taxable
Federal Reserve Bank of Kansas City

Financial Institutions

income in the year they occurred. Few thrift
institutions use this method, however, because
the reserve method generally provides greater
tax savings. Under the reserve method, losses
are charged against a reserve account rather
than income and recoveries are credited to the
reserve. Thrifts are able to make a reasonable
addition to these reserve accounts for future
losses on loans, and the net a mount transferred
is a deduction from taxable income. Tax codes
specify the meaning of "reasonable" additions
for thrift institutions , and these definitions
h ave changed over time.
From 1952 to 1962, tax provisions regarding
all owa ble transfers to bad debt reserves were so
lenie nt th at savings and loa n associations and
mutual av in gs banks paid very little Federal
in co me taxes. The definition of reasonable
additions to reserves, howeve r , was changed in
1962 and again in 1969. These changes resulted
in sign ificant increases in the taxes paid by
thrift institutions.
Table 2 shows the allowable methods of
calculating reserve additions under the Revenue
Act of 1962 and the Tax Reform Act of 1969.
In general, thrift institutions have been allowed
to make additions to a reserve on qualifying
loan s a nd to a reserve on nonqualifying loan s.
Qu ali fying loans pertain .to loans secured by
im proved rea l prope rty. mobile hom es , etc.,
while no nqu a lifying loans are unsecured or
other than qual ify ing loans. Tax-free transfers
to th e qualifying loan reserve can be computed
under one of three o ptions-the percentage of
incom e method, the experience method , or the
bank percentage method. Reserve additions for
nonqualitying loans must be based on the
loss experience for recent years. Of the three
methods available, the percentage of income
method is used by the majority of savings and
loan associations, while the bank percentage
method is the seco nd most frequently used. 3
The percentage of income method allows an
in stituti on to transfer a portion of taxable
in come to reserves. Under this method , from
Monthly Rev ew • June 1976

1962 to 1969, an institution could transfer up
to 60 per cent of its taxable income to the
tax-free reserve . The Tax Reform Act of 1969,
however , reduced this percentage to 40 per cent
over a 10-year phase-in period. The allowable
percentage fell by 3 per cent per year from 1970
to 1972, by 2 per cent from 1973 to 1976, and
will be reduced by 1 per cent from 1977 to
1979, and remain at 40 per cent thereafter.
The experience method allows an institution
to deduct an amount based on actual losses in
recent years. The amount is also related to the
volume of qualifying loans outstanding at the
end of the year. More specifically, the
experience method allows a deduction equal to
the volume of loans outstanding at the end of
th e year times a certain percentage. The
percentage is based on the ratio of losses on
loans for the most recent 6 years to the amount
of loans outstanding at the end of those years.
Prior to 1969, the provision was more liberal
in that the number of years used to calculate
the percentage was equal to the average life of
the institution's qualifying loans.
The bank percentage method , also known as
the percentage of loans method, allows an
addition to reserves in an amount necessary to
bring the total reserve up to a specified
percentage of qualifying loans. This percentage
was 1.8 per cent in 1969-75, will be 1.2 per cent
in 1976-81, 0.6 per cent in 1982-87, and will be
th e percentage computed under the experience
meth od after 1987. Prior to 1969, thrift
institutions were allowed to transfer an amount
necessary to increase the reserve to 3 per cent of
qu alifying loans outstand ing at the end of the
year.
To be eligible for these bad debt reserve
deductions , an institution must meet certain
criteria. Basically. an institution's business has
3 Edward J. Kane and John S. Valentine , "Income-Tax
Pay ment s by Savings-and-Loan Associations Before and
Afte r the Tax Refor m Act of 1969," W orking Paper No.
45. Offi ce of Eco nomic Research. Federal Ho me Loan
Bank Boar d. October 1973.

Federal Taxation of

Table 2
METHODS OF COMPUTING TAX
DEDUCTIBLE ADDITIONS TO BAD DEBT
RESERVES OF THRIFT INSTITUTIONS
Revenue Act of 1962-0ctober 16, 1962. to July 12. 1969
I.

Savings and Loan Associations
A.
Reserve additions for nonqualifying loans (all loans other than qualifying loans below)
1.
Experience method- allows a maximum addition of
nonqualifying loans)
sum of losses on unsecured loans for a number of years *
X
at the en d of the
(
sum of nonqualifying loans at the end of each year )
current year
(

* The number of years used is equal to the average life of the institution's nonqualifying loans.
B.

R eserve additions for qualifying loans (loans secured by an inter es t in improved rea l prop er ty or by an
interest in real property which is to be improved out of th e proc ee d s of t he loan)
1.
Experience m ethod- same as A above u sing qu al ifying lo ans.
2.
Perc ent age of i ncome m ethod - allows a maximum addition of 60 p e r ce nt of tax abl e incomet less
th e amount transferred in A above.
L i mitation s:

11 .

a)
b)
c)

A net operating loss cannot be crea t ed by th e d eduction .
The reserv e ca n not e xceed 6 per cent of qualifying loans outstanding at th e end o f the ye ar .
The reserve addit i on cannot exceed 12 pe r cent of th e differe nce b etwee n total deposits ar

the close of the year and su rp lus, undivided profits, and reserves at the beginning of th e ye ar.
The association must primarily engage in acquiring savings of the publi c and investing in

certain loans . Mo st notably th is required that at l east 82 per c ent of a n institution ' s total
assets be represented by residential mo r tgages, cas h , gov ernment secur it ies , and passbook
l oans .
Percentage of re al property loans m ethod - · allows a maximum t ra nsfer of the amount necessary
to incr ease the reserve to 3 per cent of such loans out standing at th e close of th e y ear. f
L imita tions : See c and d under 82 above .

Mutu al Savings Banks -same as for I above ex cept und er B2 , l imitation d, 72 per cent of an i nstitut io n' s inves tmen t s had to b e in th e specified catego r ies.

tTaxable i ncome is c omput ed before any net operating loss carryb;;ick and d edu ct ion s f o r bad d eb ts , c harit abl e contribu tion s, and certai n other it em s.
tNonc api ta l stoc k companies in operati on less than 10 y ears w ere all owed an additional amount .
§T axabl e inco m e is computed before th e deduction for bad d ebt reserve addition s and by excluding from gro ss inco m e
net gains f rom the sa le of certain st ocks and bonds , 3 / 8 of net long-t erm ca pit al gains, divi de nds, and som e othe r ite ms
of i ncome . The port i on of th e nonqualifying reserve addition th at must be d educted i s equ al to t he ratio of 18 p er
cen t (28 p er cent f o r a m utual savi ngs bank) to t he p erce ntage of assets in non sp ecif 1ed c ate gor ies.

to consist of acquiring savings of the public and
investing them in certain loans and assets
within specified limits. Most notably , the latter
restri ction reg uires that at least 82 per cent of a
sav ings a nd loan association's investments and
72 per cent for a mu tual savings bank be in
residential
mortgages , cas h,
government
8

securities, a nd pass book loa ns. Under the 1969
Tax Reform Act , this rule was rela xed
somewhat a nd all owed a n institution not
meetin g the full asset requirements to dedu ct a
portion of taxable income according to a sliding
scale. That is, the perce ntage of tax ab le income
dedu ctible declines as the percentage of assets
Federal Reserve Bank of Kansas City

Financial Institutions

Table 2
METHODS OF COMPUTING TAX
DEDUCTIBLE ADDITIONS TO BAD DEBT
RESERVES OF THRIFT INSTITUTIONS
Tax Reform Act of 1969-after July 12, 1969
Ill.

Savings and Loan Associations
A.
Reserve additions for nonqualifying loans
1.
Experience method-allows a maximum addition of
sum of losses on non qua I ifying loans in the most curren t 6 yea r s\
(
B.

sum of unsecured loans outstanding at the end of each year

Reserve additions for qualifying loans (loans
certain other loans)
1.
Experi ence method- same as A above
2.
Perce ntage of income method - allows
income less the amount transferred in
60%
57 %
54%
51 %

in
in
in
in

(

nonqual ifying loans)
at the end of
the current year

secured by real property, mobile homes , urban renewal, and
using qualifying loans.
a maximum addition of the applicable p ercentage of taxable
A above§ wh ere t he applicable perce ntage is:

1969
1970
1971
1972

49%
47%
45%
43%

in
in
in
in

1973
1974
1975
1976

4 2% in 1977
41 % in 1978
400/o in 1979 and thereafter

Limitations :
a)
See I82a. b, and c.
b)
An institution had to meet the requ ireme nts of 182d, but the percentage of income deductible would be reduced by ¾ of 1 per cent for each percentage that qualifying assets fell
below 82 per cent. Qualifying assets cannot fall bel ow 60 per cent of total assets.
3.

Bank percentage or percentage of quali fying loans method-allows a maximum addition of an
amount necessary to increase the reserve at the end of the year to the applicable percen tage of
el i gible loans outstanding at the end of the y ear le ss the amount tran'sferred in A above, where the
app lic able percentage is :
1.8% in 1969-75
1.2% in 1976-81

0 .6 % in 1982-87
The p ercentage computed under
the experience m ethod from 1988
and thereafter.

L imitations : See I82c .
IV .

Mutual Savings Banks- same as Ill above except under B2, limitation b, th e percentage of income deduction is
reduced by 1.5 p er cent for ea ch 1 per cent difference between 72 per cent of total assets and assets held in the
specified categories . Th e specified assets must be at least 50 pe r cent of total assets before 1973 and 60 per cent
after 1973 to use the percentage of income method.

in the specified categories declines. However, a
thrift institution holding less than 60 per cent
of assets in the specified categories is ineligible
for the percentage of income method.
Reflecting the tax changes made in 1962,
bad debt reserve deductions taken by savings
and loan associations fell by nearly one-third
Monthly Review• June 1976

from 1962 to 1963. As a result , the effective tax
rate of savings and loans rose from 0.4 per cent
to 12.2 per cent. After the 1969 tax revision ,
the bad debt reserves of savings and loans
posted an increase in dollar terms, but fell
substantially as a per cent of taxable income.
As a result , the effective tax rate in 1971 was
9

Federal Taxation of

about 10 percentage points higher than would
have prevailed under the provisions prior to
1969.
In addition to the changes in the
computation of bad debt reserves for financial
institutions, the Tax Reform Act of 1969
instituted a minimum tax on preference items
of income. Tax preferences include accelerated
depreciation on real property and personal
property subject to a net lease , amortization of
certain facilities, stock options, depletion ,
capital gains, and reserves for losses on bad
debts of financial institutions. These items are
subject to a second round of taxation at a flat
rate of 10 per cent after an exclusion of $30,000
plus al l Federal taxes paid during the year. The
impos ition of this tax was important to
financial institutions because of their large
reserves for losses on bad debts. The minimum
tax rate applies to the amount by which the
"reasonable" addition to the reserve for the
taxable year exceeds the amount that would
have been allowed if the institution had used
the experience method. Excess bad debt
reserves account for nearl y all of thrifts '
preference items. For the 1970- 73 period , this
seco nd round of taxation on preference income
raised the effective tax rates of savings and loan
associations about 2 percentage points.
The continuing erosion of tax-free additions
to bad debt reserves and the imposition of the
tax on preference item s contrib uted greatly to
the upward trend of thrift institutions' effective
tax rates. However , the sliding scale provision
for using the percentage of income method
allows institutions to diversify their assets to
utilize other tax shelters while still obtaining a
significant benefit from the bad debt
deduction. For example, when the full
reduction in the allowable percentage of
taxable income has taken place in 1979, a n
in sti tuti on maintaining onl y the minimum level
of qualifying assets, 60 per cent, could still
shelter nea rl y one-fourth of its taxable income
through transfers to bad debt reserves.
10

Other Tax Shelters. The decline in the tax
advantages obtained by transferring funds to
bad debt reserves and the imposition of the
minimum tax on those reserve additions have
encouraged thrift institutions to seek other
methods of tax reductions.
One approach open to thrift institutions has
been to increase their holdings of tax-exempt
state and local securities. Holdings of these
assets, however, represent only a small portion
of the asset portfolios of thrift institutions. In
1975, state and local securities accounted for
less than 1.5 per cent of the total assets for
both savings and loans and mutual savings
bank s. In many cases municipal securities are
held only to help satisfy regul atory liquidity
req uireme nts. Non eth eless , tax -free incom e
from state a nd loca l obligations can be a
significant aid in reducing taxable income,
particularly for
large
institutions.
For
institutions in the highest tax bracket, there is
generally a greater after-tax return from
tax-exempt securities even though the pretax
return may be considerably lower than on
taxable securities. Smaller institutions , though,
may find it more advantageous to invest in
higher yielding taxable securities , particularly
when costs of selling securities are considered.
Another tax advantage for thrift in stitutions
can a ris e from securities transactions . In 1952.
thrift instit ution s were granted the sa me tax
advantages as commercial banks wi th rega rd to
the sa le or exc hange of sec uri ties. Financial
in stitutions were allowed to treat net long-term
gains on sales of securities as capital gains
while treat ing net long-term losses as ordinary
deductions from income. Thus, if an institution
in the highest tax bracket alternated years of
taking gains and losses, its gains would be
taxed at the lower capital gains rate of 25 per
cent and about half of its losses would be
absorbed by the Intern al Revenue Service. The
Tax Reform Act of 1969 req uired that thrift
institutions treat both gains and losses on
sec uri ties and mortgage sales as ordinary
Federal Reserve Bank of Kansas City

Financial Institutions

income and thus reduced the benefits from
alternating years of gains and losses, although
it did not entirely eliminate those benefits.
Prior to 1969, thrift institutions obtained
another benefit from securities transactions.
Long-term capital gains were included in
taxable income when using the 60 per cent of
taxable income deduction for computing bad
debt reserves. Thus , long-term gains increased
the bad debt deduction when reserves were
below ceiling levels. In many cases, this
reduction in taxes more than offset the increase
in taxes from the 25 per cent rate applied to the
net long-term capital gain. 4 Since 1969, the
percentage of income method for computing
bad debt reserves requires thrift institutions to
excl ud e from taxable income a portion of net
long-term capital gains for the taxable year. In
addition, capital gains are considered a
preference item and are therefore subject to the
minimum tax rate. These changes in tax laws
regarding security transactions further served
to erode tax advantages of thrift institutions
and contributed to the rise in their tax burdens.
Beginning in 1962, corporations were allowed
to take a credit against taxes for investment in
new equipment and machinery. The credit was
equ al to 7 per cent of the full amount of such
investments . 5 However, thrift institutions were
limited to a credit on only 50 per cent of their
qualifying investment up to a maximum of
$12,500 plus the applicable percentage over
that amount. The investment tax credit was
raised to 10 per cent for the period from
January 22, 1975, through December 31 , 1976,
4 Federal Inc ome Taxation of Banks and Fin a n cial
In stitution s. W a rren. Gorham, and Lamont. Inc., Boston ,
1971.
5 The a mount of the investment to which the credit app lies
is $25.000 plus 25 per cent of all amounts over th at (50 per
cen t for years afte r M arch 10 , 1967). The in vestmen t tax
credit has rema in ed in effec t excep t for two short periods of
suspension from October 1966 to M arch 196 7 a nd from
April 1969 to December 1970. During the first period,
$20.000 of new invest ment was exe mpted from the
suspens ion.
Monthly Review • June 1976

but thrift institutions still receive only half the
credit. Thus, the investment tax credit has
resulted in a smaller tax benefit to thrift
institutions than to other corporations. 6
The justification for
thrifts'
smaller
investment tax credit allowance was that they
were already given generous tax benefits under
the special provisions for transfers to bad debt
reserves. Thrift institutions also receive smaller
investment credit benefits than commercial
banks and other corporations because they do
not engage directly in leasing activities which
allow investment tax credits. Still , investment
tax credit deductions may have encouraged
thrift institutions to invest in expensive
computer equipment and expand their
electronic funds transfer operations rapidly in
recent years.
Thrift institutions take almost no foreign tax
credits. Savings and loan associations are not
engaged in foreign activities or branching and
only a small number of mutual savings banks
operate in this area.
COMPARISON OF THE TAX BURDEN
OF THRIFT INSTITUTIONS
AND COMMERCIAL BANKS

As shown in Chart 1, the Federal tax burden
for savings and loan associations and mutual
savings banks has risen sharply since 1962,
while the tax burden for commercial banks has
declined. As a consequence, the tax burden in
1975 was 24.0 per cent for savings and loan
associations , 12.4 per cent for mutual savings
banks, and 13.5 per cent for commercial
banks.
Differences in the tax laws for thrifts and
commercial banks do not appear to be a prime
6 Thrift institutions can receive the full in vest ment credit
on purchases made by a service corporat ion or sub sidiary.
Service corporations have grown since 19 70 when the
Federal Home Loan Ba nk Boa rd relaxed restrictions on
their act ivi ties. Leasing act ivit ie s of sav in gs and loa n
associations are usually carried on t hroug h these
subsidiaries .

FPrlPral Taxation of

factor accounting for the differences in tax
burdens at the present time. Available tax
shelters are generally the same for thrift
institutions and commercial banks , and tax
laws regarding these shelters are similar in
many ways for both groups.
One minor difference in the tax laws is in the
treatment of bad debt deductions. From 1954
to 1964, commercial banks were permitted
rather generous additions to bad debt reserves , 7
as were thrift institutions in the 1952-62 period.
Beginning in 1965, though, tax laws applying
to banks were made more restrictive, with
banks allowed to build up reserves equal to
on ly 2.4 per cent of eligible loans outstanding
or to use the experience met hod based on losses
over the past 6 years. Under the 1969 Tax
Reform Act, tax laws regarding bad debt
reserves were equalized for thrift institution s
and commercial banks, but thrifts meeting
certain asset requirements could choose a
percentage of income method which usually
resulted in larger tax deductions.
Another minor difference in the tax laws for
the two groups relates to the investment tax
credit. Commercial banks are allowed the full
investment credit, as are other corporations,
while thrift institutions are allowed only hal f of
the credit. Thus, differences in tax laws for the
two groups are few and essentially min or. How,
then, is it possible that commercial banks have
red uced their tax burdens while effective tax
rates paid by savings and loan associations and
mutual savings banks have increased?
A principal reason for the marked difference
in the trends in the tax burdens of thrifts and
com mercial banks relates to the ab ility of
institutions to utilize available tax shelters.
Generally speaking, the ability to utili ze tax
shelters is associated with the asset structure of
7 Lo an losses were ca lc ul ated by a n experience meth o d
U\ing a 20 -yea r ave rage. This average ofte n included the
Deprc\si o n years of the I 9JO's wh e n loan losses we re
hi\tori c ally hi g h and res ult e d in bad debt deducti o n s
g n.: atly in c xces\ of banks' rece nt experience.

the institution and the flexibility it has to shift
assets to capitalize on tax shelters or substitute
new tax advantages for eroding shelters. Thrift
institutions, for example, are primarily engaged
in mortgage lending activities . Mortgage loans
accounted for 82 per cent of savings and loan
associations' total assets in 1975, while other
loans and securities amounted to only 9.2 per
cent of their portfolios. Mutual savings banks
were somewhat more diversified with 64 per
cent of their assets invested in mortgage loans
and 31.6 per cent in other loans and securities.
Thus, thrift institutions are largely limited to
the use of tax shelters related to mortgage
loans-at the present time only the bad debt
reserve deduction i such a shelter. Commercial
banks, however, held only 14 .2 per cent or th eir
assets in mortgage loans in 1975 with 42.4 per
cent of their portfolio in ot her loans and 23.5
per cent in investment securities . Thus.
commercial banks are able to utili ze a number
of the tax shelters available to financial
institutions. In addition, laws other than tax
codes can affect an institution's ability to use
tax shelters. Regulations ;·egarding involvement
in foreign and leasing operations are more
liberal for commercial hanks than for thrift
institutions ,
thus
affording
banks
the
opportu nity for greater tax credits and
tax-sheltered depreciation deduction .
To gain further in sight into reasons for
differences in effective tax rates among
financial in stitu ti ons, it is useful to exa mine
relative tax burdens by size of institution. In
1970, for exa mple , all size groups of savings
and loan associations and mutual savings
bank s paid lower effective Federal tax rates
than equivalent commercial bank size gro up s.
By 1975, though, the picture had changed
dramatically. As Chart 2 shows, savi ngs and
loan associations in all asset size categories
except the smallest had a hi gher tax burden
tha n commercial banks. In th e case of mutual
sav in gs banks, a similar but sli ghtly different
picture emerges. Commercial banks had lower

Financial Institutions

Chart 2
COMPARATIVE 1975 TAX BURDENS BY SIZE OF INSTITUTION

Per Cent
Per Cent
30.0 - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - 30.0

LoT Associations

Insured Savings and
25.0

25.0

20.0

15.0

'--------',
',

10.0

' ,__

Insured Mutual Savings Banks

20.0

, _______

15.0

-...

...

,,,, ,"

10.0

Insured Commercial Banks
5.0

0[1
0 - 10 ·
10-25
Mill ions of Doi lars
Asset Size

5.0
I

25-50

50-100

100-250

250-over

*Th e smallest size category has been o mitted for mutual sav in gs banks since it contains only f ive
institutions and data were distorted by th e unusual behavior of one bank .

tax burdens than mutual savings banks with
the exception of two asset size categories.
Mutual savin gs banks with assets over $250
million had a tax burden below that of
commerci a l banks , while savings banks in the
$10-$25 million asset category had a tax burden
below commercial banks but th e difference was
negligible.
The · lower tax burden for small th rift
in sti tuti ons points out the importance of the
bad debt
reserv e deduct ion
for
these
instit ut ions vis-a-vis commercia l banks. Smal l
comm ercia l bank s. it has been found, te nd to
utilize few tax shelte rs. Moreover, ma ny of
these institutions use the spec ific cha rge-off
Mor•thly Rf?v1Pw • Ju'1f' '976

method of accounting for loan losses rather
than the reserve method which provides greater
tax reductions. Small com m ercial banks a lso
are rarely engaged in foreign or leasing
activities and the tax reductions obtained
through securities swaps or investment in
municipal sec uriti es are often minimal because
of the banks' lower tax bracket. In contrast,
small th r ift institutions normally use the reserve
met hod of accounting for loa n losses and thus
rea li ze reductions in their ta x burdens. M os t of
th ese smaller thrift in sti tutions pay no
minimum tax on their bad debt transfers
because of the large exe mption given on
preference income. Thus. the bad debt reserve
13

Federal Taxation of

deduction is an important factor in allowing
small thrift institutions to post lower tax
burdens than small commercial banks.
As shown in Chart 2, larger savings and loan
associations pay higher effective tax rates than
similar sized commercial banks. For savings
and loan associations, the tax burden generally
increases with the size of institution. For
commercial banks, in contrast, the tax burden
declines as bank size increases up to the largest
bank size.
The rise in the tax burden of savings and
loan associations as size increases results partly
from the progressive nature of the corporate tax
structure and partly from the second round of
taxation on preference income. The corporate
tax rate in 1975 was 20 per cent on the first
$25 ,000 of taxable income, 22 per cent on
income of $25,000 to $50,000 , and 48 per cent
on all income over $50,000. 8 Despite this
progressive tax structure, however, the tax
burden of savings and loans peaked in the $50
to $100 million range during the late 1960's, as
larger institutions were more efficient in
sheltering their income than smaller
institutions. With the implementation of the
minimum tax in 1969, though, the tax burdens
also increased for the larger institutions. In
1971 , t he minimum tax on preference income
raised the effective tax rate only 0 . 1 per cent for
savings and loan associations with total assets
less than $10 million, but the tax burden was
increased to 2.3 per cent for associations with
over $100 million in assets.
The general decline in the tax burden of
commercial banks as size increases results from
the relatively small impact of the minimum tax
and the increasing ability to shelter income.
The largest tax advantage for commercial
banks is derived_from investment in municipal
sec urities and this interest income is not subject
to th e minimum tax. Also, as size increases,
8 Fro m 1965 to 19 74 . th e corporate tax rate was 22 pe r cen t
o n the fir st $25.000 of taxabl e in co m e a nd 48 per cent on
in come ove r $25,000.

banks have greater flexibility to shift to taxsheltered activities and are better able to utilize
accounting and tax experts to reduce tax
liabilities. Not only have the larger banks been
able to utilize the traditional tax shelters for
financial institutions, but they have also
adopted other tax savings programs such as
accelerating depreciation, offering equipment
leasing programs, taking investment and
foreign tax credits, and benefiting from merger
and holding company accounting rules.
Although the effective tax rate of banks
generally falls as bank size increases , banks in
the largest asset size category experienced a
slightly rising tax burden. This tendency
appears to reflect the effects of the progressive
corporate income tax structure and the fact
that the largest banks held a small er proportion
of assets in municipal securities than did banks
in other size groups.
As thrift institutions diversify their activities
and as their size increases, they too can be
expected to make greater use of available tax
shelters . There is some evidence that this shift
has already begun. In the 1971-74 period, when
tax laws were not changed, the general rise in
tax burdens tended to fall as size increased.
Tax burdens rose 6.6 per cent for savings and
loan associations with assets of $10 to $25
million but increased only 3 .6 per cent for
associations with assets over $100 million. This
pattern was interrupted in 1975 since the
c h a n g es i n corpora t c t a x r a t cs b c n e f i t e d
medium-sized institutions more than larger
institutions. The shift to the greater use of tax
shelters other than bad debt reserve transfers
has also taken place at mutual savings banks,
particularly the larger ones. Mutual savings
bank s increased the percentage of interest-free
income from municipal securities to net income
before taxes from 2.7 per cent in 1971 to 13.9
per cent in 1975. This ratio rose even more
rapidly at large mutuals, enabling them to
reduce their tax burden below that paid by
medium-sized mutual savings banks. Thus, tax
FP.dera RP.serve Bank of Kansas City

Financial Institutions

laws and the use of tax shelters can affect not
only the share of the tax burden among varying
types of institutions but also the tax burden
among various size groups within the same type
of institution.
SUMMARY AND CONCLUSION
Changes in tax laws since 1962 have resulted
in an erosion of the tax shelters available to
thrift institutions and led to a sharp increase in
their Federal tax burden. The tax burden for
savings and loan associations was 24.0 per cent
in 1975 and for mutual savings banks it was
12.4 per cent. Commercial banks, on the other
hand , experienced a reduction in the ir tax
burd en to I 3.5 per cent in 1975. Tax burdens ,
however. vary great ly with the size of the
inst itutio n. Smaller commercia l banks and
mutual sav ings ba nk s do not benefit as
sign ifica ntly from tax shelters as larger banks,
while large savings and loan assoc iations pay
higher tax rates than smaller institutions.
Recent ly proposed changes in tax laws could
greatly alter the relative tax burden of financial
institutions . One such major proposal is a plan
for a mortgage tax credit. 9 This credit would
allow a deduction from taxes equal to a
perce nta ge o f an institution's resid entia l
mortgage interest income. Since thrifts a lread y
hold a large proportion of their assets in

Monthly Review • June 1976

mortgages , they would probably benefit more
from this credit than commercial banks.
Another proposal that could alter the
comparative tax advantage of commercial
banks is a Federal subsidy for interest
payments of state and local governments
issuing taxable securities. According to the
proposal , the subsidy would be greater than or
equal to the difference in interest costs on
taxable and nontaxable securities so as to
encourage municipalities to issue the taxable
sec urities in favor of tax-exempts. 10 To the
extent this occurs , commercial banks would
have less opportunity to earn tax-free income.
Thus, the combination of the mortgage tax
credit and the e limination of tax-exempt
municipal income co uld greatly reduce the tax
burden of thrift relative to that of commercial
banks.
9 With the institution of a mortgage tax credit , the
percentage of income method of computing thrifts' bad
debt reserves would be eliminated, and all financial
institutions wou ld use the experience or bank percentage
reserve methods. However, the Treasury has estimated that
the mortgage tax credit wou ld result in a greater tax benefit
to thrift institutions than the current bad debt deduction.
See Statem ents to House Budget Committee Task Force on
Tax Expenditures at Hearing, February 25, 1976, on
Proposed Mortgage Interest Tax Credit.
10 See Joint Committee on Internal R even ue Taxation
Report in House Ways and Means Committee Heari ngs on
HR 12774. March 30, 1976.

UNEMPLOYMENT INSURANCE
Part II: Programs and Problems

By Steven P. Zell
interest in the operations and
P opular
objectives of the unemployment insurance
(UI) system tends to vary directly with the state
of the economy. While even in the best of times
over 1 million claims for benefits are processed
nationally each week, the system has rarely
been a subject of national debate. However, in
recessionary periods , when unemployment rises
and the financial resources and claims
processing capacity of the system are strained,
questions are increasingly raised as to the
proper role and characteristics of the UI
program.
Beginning in the third quarter of 1974, the
United States experienced its most rapid rise in
unemployment since the end of World War II.
Beca use much of this increased joblessness was
among wage and salary workers with
un employment insurance eligibility, the UI
system soon experienced an unprecedented
drain on its resources. As unemployment
continued to grow and more and more workers
exhausted their regular unemployment benefits , Congress enacted new programs to extend
the duration of benefits and to expand UI
coverage to previously excluded groups of
workers . This tremendous growth in benefit
pa yments has resulted in the bankruptcy of 20
state programs, extensive borrowing by these
states from the Federal Government , the
introduction before Congress of several bills to
s ignificantl y revamp the system, and
16

considerable debate on the future of
unemployment insurance.
This article is th e econd part of a three- part
stud y which attempts to clarify the iss ues
in vo lv ed in the current debat e on the
unemployment insurance system. 1 Expanding
on the discussion of the programs and
procedures of the UI system presented in Part
I, this article begins with an examination of the
disparity which exists among the states in their
regular benefit programs . It concludes with a
discussion of the extended benefit and
expanded coverage programs which were
pl aced in effect during the recent recession .
The final article in this series, to appear in a
subsequent Monthly R eview. will discuss some
of the major criticisms and problems of th e
system and some of the proposed solutions to
these problems.
REGULAR STATE PROGRAMS:
VARIATIONS ON A THEME

The Federal-state system of unemployment
compensation has grown tremendously since its
creation during the Great Depression. The
Di vision of Actuarial Services of the United
I "Un e mpl oy m e nt In s uranc e Part I: Programs a nd
Procedures," wa s publish e d in th e February 1976 issue of
thi s R e view . It e xamined the hi s t o r y, objec ti ves,
termin ology. a nd p roced ures of th e UI system . wi th
particular em ph as is on the o peratio n of th e Mi sso uri
Di visio n o f Empl oy m ent Securit y.

FPderal Reserve Bank of Kansas City

Unemployrnert hsurance

States Unemployment Insurance Service (UIS)
estimates that in fiscal year 1976 , benefit
payments for all programs will exceed $18
billion, approximately 8 times the benefits paid
only 10 yea rs earlier. 2 Of these expenditures,
which exclude salaries and other administrative
expenses, almost $12.5 billion will be spent on
benefits under the "regular" state programs.
All 50 states, Puerto Rico , and the District of
Columbia a re members of th e UI system, and
in eac h of these " states," an un employed
worker seek ing UI benefits files a claim under
that state's r eg ular benefi t program.
Nevert heless, a tremendous diversity exists
among th e sta tes in a ll aspects of th e program .
It is safe to say that no two sta tes have quite the
same e ligibi lit y req uir e m e nts, co e rag ,
methods for determ inin g eit her weekly benefit
size or duration, or the same penalties for
various disqualifying acts .
In pa rt. t he proble m exists beca use there are
no Federal standards for determinin g benefit
eli gibility, size . or du ration , and only limited
guidelines a nd requirements for job coverage
and program financing. 3 The following section
d isc usses some of the reasons for the variety of
met hods used amo ng the states for determining
be nefit ri ghts and briefly examin es some of th e
meth ods in use today .
Benefi t Eligibility

The framev,•o rk for the un employment
in sur ance system was estab lished in 1935 by

2 Jam es Manning. Chief. Divisio n of Actuaria l Service,
U ne mpl oy ment Insurance Service. U.S. Departme nt of
Lab o r. telephone interview. January 27 . 1976. The a uthor
is e~ pecially indebted to Daryll Bauman of the Kan sas City.
Mo . Region a l Office of the U IS fo r h is assistance in
clari(ying man y of th e concepts a nd operations o f the
\ ystem.
J Sec ln /iir11w1 io11 0 11 U11l'mp loy11w 11 1 a nd U11 employmen t
Co 111 pl'11sa 1io11 Programs . Subcommittee o n U nemployme nt
Co mpensa t io n. Hou se Com mitt ee o n Ways a nd Mea n s.
September 22. 19 75 . pp. 3-6 . for a dis cussio n of fin anc in g
and cove rage requireme nt s.

Mon'hly Rf'v

AVv • JL.

e 19/6

Titles III and IX of the Social Security Act. 4
During the next few years, when the states were
enactin g their UI legislation , it was generally
agreed that eligibility for insurance benefits
should depend on the number of weeks the
unempl oyed claimant had worked in covered
e mpl oy ment during some spec ified prior
period, known as his base period. s According
to the d evelopers of the program:
A requiremen t of this kind is necessa ry to prevent the [U I trust ] fund from becoming depleted
at th e expense of regula rl y employed workers by
the payment of benefits to perso n s who work o nly
inte rmittently. spasmod ically, o r for brief season a l
pe riods in compensable employ ment. 0

The program was thus aimed at aiding the
regul a rly employed wo rk er , and the eligibility
req uirement were designed more to exclude
workers of qu es tionable labor force attachment
than to id entify deserving workers.
Originally, t he states intended that when a
claima nt filed fo r unemployment compensatio n, his fo rmer employers would be
contacted to provide information on the actual
number of weeks he worked during his base
period. This weeks-of-work eligibility requirement was predicat~d on the belief that the
longer his period of prior employment, the
stro n ger was the wor k e r's labor force
attachment. However, the difficu lties involved
in contacting for m e r em plo ye rs for data
whenever a claim was fil ed soon became
apparent. Not on ly we r e data proce ss in g

4 The historical perspective o n eligibility requirements is
drawn. in part , from George S. Roch e , Enritlemem to
Unemployment Insurance Benefits ( Kalama zoo: W. E.
Upjohn Institute, Septembe r 1973), ch. 3. pp . 29-46.

5 Covered e mployment consists of those jobs specified in
the U l leg islation as subject to the UI taxes wh ich finance
the program . In most states. the claima n t's base p er iod
co nsi sts of th e first four of the last five comp le ted ca le ndar
quarte rs preceding the present bout of unemployme nt. For
a precise definition of the important terms used in
discussing the U I syste m , see Z e ll . "Unemployment
In sura n ce. P a rt I ...
6 Social Sec urity Board. Socia l Secu rity in A m e rica
(W ash ing ton: Governme nt Printing Office. 1937). p. 123 .

Unemployment Insurance

capabilities extremely limited at the time, but
workers often forgot the names of their former
employers, and frequently, employers were
either out of business, lacked the necessary
work records, or were unwilling to cooperate.
From an administrative standpoint, a
superior method for computing eligibility was
found in the use of employee wage records from
emp loyers' quarterly tax returns. The states
had been collecting these returns for many
years, and by using them , a proxy fo r the
number of weeks worked could easily be
calculated. One proxy requirement that was
constructed specified that to be eligible for a
given weekly benefit a mount (WBA) , workers
must have earned a fixed multiple of this WBA
entitl ement during that quarter of their ba e
period in which they had their highest total
dollar ea rnings. Since all but 4 of the SJ
jurisdictions in the UI sy stem in 193 7
established their WBA so as to compensate 50
per cent of lost wages (up to a relatively high
maximum), an eligibility requirement that a
claimant must have earned , for example , 20
times his WBA in his high quarter, indirectly
required that he had worked 10 weeks at
full-time wages. 7
By J 939 , the first year that all the states were
paying benefits , three eligibility requirem ents
were in use. While only 3 states continued to
use a weeks-of-work requirement, 32 had
adopted the proxy of some multiple of WBA,
and 16 had chosen a flat d ollar requirement for
base period earnings. Yet, even among the 32
states with a multiple-of-WBA requirement ,
differing attitudes as to who should be
compensated led to the legislation of

7 On th e as sumption th at the wages ea rned in this high
quart e r were earned at the claimant' s normal weekly level ,
th e average weekly wage lost due to un e mpl oy me nt was
o btained by dividing these high quarter wages ( HQW ) by
13 wee ks . Th e week ly benefit amount that th e claimant
would rece ive if e ligible for benefits was then determined by
th e percentage of lost weekly wages that the state wi shed to
re place .

substantial variability in the actual number of
weeks of work required to establish eligibility .
Furthermore, the two proxies for weeks-of-work
were biased against low-income workers. The
requirement that earnings equal some multiple
of WBA allowed those workers who were
eligible for the maximum benefit level to
qualify for benefits with fewer weeks of work
than were required of lower income workers.
The flat earnings requirement , though simple
to administer, also had this property.
During the static 1930's, these original
eligibility proxies were, though imperfect , at
least stable approx imation s of the number of
week actually worked. They became far less
useful , however, as the econ my expanded in
the 1940' a nd beyo nd. As wages grew rapidly
while employer group pressure kept minimum
and maximum benefit levels from rising as fas t,
more and more workers could qualify for
benefits , often with fewer or more intermittent
weeks of work than was originally intended.
Because many previously ineligible groups of
workers became eligible to receive benefits ,
states attempted to patch up their eligibility
proxies with more stringent add-on provisions,
with stricter disqualification regulations often
aimed at specific groups, or finall y, with
different proxies. The hodgepodge of rul es and
regulations that exists today is the direc t result
of differing attitud es toward e ligibility and the
var ied, but ge nerally unsuccess ful, approaches
taken to try to restore th e original relationships
between the number of weeks actua ll y worked
and its proxy measures.
Currently four such eligibility measures are
used, each pertaining to activ ity during the
claiman t's base period: a specified number of
weeks of prior employme nt , by 25 states; a
multiple of high quarter earnings (generally
about 1.5 x HQW) by 13 states; a multiple of
the weekly benefit amou nt, by 3 states; and a
flat earn in gs requirement, by 4 states.
Furthermore, most of the states use one or
more requirements in addition to the principal
F-ederdl Reservp Bank of Kan:::>dS C y

Unemployment Insurance

one . 8 For example, Missouri stipulates that an
eligible claimant must have earned 30 times his
WBA , $300 in one quarter, and some wages in
at least two quarters. These overlapping
requirements are part of the patch-up
procedure mentioned earlier , and were
introduced as the weaknesses of each of the
individual met hods were recognized.
Benef it Size
A longtime objective of the UI system has
been to try to compensate eligible insured
workers at a level equal to about 50 per cent of
their lost full-time weekly wages. However, even
at th e beginning of the system, a maximum
benefit amount was deem ed necessary in order
to a void paying "excessively" large benefits to
high wage workers. In 196 5, the U.S.
Department of Labor estimated that if this
maximum benefit amount was set at two-thirds
of th e statewide ave rage weekly wage in covered
employment (A WCE) , approximately 80 per
cent of the insured workers would receive at
least one-h alf of their lost weekly wage should
they become unemployed.
In July 1969. the Nixon Administration
offi cia ll y asked the states to increase their
ce ilin gs to at least this leve l of coverage. At that
tim e on ly one state, Hawa ii, had its maximum
weekly benefit eq ual to 65 per cent or more of
its A WCE, while 21 states paid maximum
benetits of at leas t 50 per cent of that wage
level. Changes in the direction of greater wage
repla ce me nt, however, have been relatively
slow . As of July 1975, only 14 states had
enac ted benefit maximums of at least 65 per
cent of average covered wages while maximum
Q

8 See "Sig nifi cant Provisions of State Unemployment
In s ura n ce Law s . Ja nuary 5, 19 76... E mpl oyment a nd
Tra ini ng Admi ni s tr a tion. U .S . Departm ent o f Labo r ;
Roc he . pp . J 3- 44; a nd Stre11gth e11i11g Un employ m ent
!11 s 11 n111 c1' ( Kal a mazoo: W. E . U pj o hn In sti tut e . M ay
19 75 ). pp . 22- 24.
9 In 1939 . when a ll o f the then 5 1 states began payin g
bcnclit s . 23 paid maximum benefits of at least 65 per ce nt.
and 46 o f a t least 50 per ce nt of A WCE .

Month I y R view • June 1976

benefits in 45 states equaled or exceeded 50 per
cent of A WCE. 10
In addition to their differences in legislated
maxim um weekly benefit levels , the 52 states
also use three distinct methods and a variety of
fo rm ulas in calculating from past wages the
actual weekly benefit amount (W BA) to which
claimants are entitled . The great majority of
the states (39) calculate WBA as a fraction of
hi gh quarter wages (H QW). On the assumption
of 13 weeks of work in the high quarter, a
fraction of l /26 yields benefits equal to half the
average full-time week ly wage earned.
However, recognizing that m any workers have
some unemployment even in th eir high earn in gs
q uarter, most states use a fraction somewhat
greater than 1/26 . The result of th is is t hat
workers who actua lly worked 13 weeks can be
compensated at more than 50 per cent of their
lost wages (up to the maximum benefit level).
In addition, since high qu arter earnings often
includ e bonuses, overtime pay, and back wages
from a previous quarter, the implied high
quarter weekly wage often tends to overstate
previous wage levels. Fractions used by the
states now range from 1/20 to 1/26, with six
states employi ng a vari able formul a paying a
la rger frac tion to lower income workers.
The two oth er methods that are used to
determine a claimant's WBA calculate it as
eithe r a per ce nt of his average base period
weekl y wage (ni ne states), or a per cent of his
tota l base period earnings (four states) . This
latter method is t he easiest of the three to
administer and also provides a means to rest rict
the benefit payments of seasonal workers with
low ann ual earnings but sufficient high qu a rter
credits to qualify for be nefits. Its major
disadvantage is tha t it "produces WB A 's that
bear no consistent relationship to t he actual
weekl y wages earned by many claimants·· who
10 Th e qu es t ion o f wha t level of wage re placement is t he
soc ia lly opt im a l o ne. g iven wo rk di since ntive effect s . is by
no m eans set tl ed. a nd wi ll be a ddressed further in the fina l
a rt icl e in thi s se ries .

Unemployment Insurance

are not seasonal workers. 11 Because of this, two
claimants from the same state with identical
wage levels but different amounts of
employment during their base periods may be
entitled to very different WBA 's.
Benefit Duration

Like the procedures for determining weekly
benefit size , the methods for establishing the
duration of benefits to which a claimant is
entitled also vary greatly among the states. The
principal distinction is that between the nine
states providing a uniform duration of benefits
to all eligible claimants and those using a
variable duration formula. Of the uniform
duration states, Puerto Rico provides 20 weeks
of benefits, Pennsylvania 30 weeks , and the
remaining seven states , 26 weeks. Among the
variable duration states, the great majority (34)
provide for a maximum duration of 26 weeks of
benefits , with the remaining nine states
specifying maximums of from 28 to 39 weeks.
This strong consistency , however, is more
apparent than real. In all but eight of the
variable duration states, the period of benefits
to which a claimant is entitled is determined by
two factors: the state's WBA formula and some
specified fraction, usually 1/ J to ½, of his base
period earnings in covered employment. 1 2 By
this method , th e claimant's maximum benefit
du rat ion is obtained by dividing his WBA
entitlement into the given fraction of total
wages . Thus, for example , if a claimant earned
$3 ,000 in his base period, and the allowed
fraction was 1/J , the maximum amount of
benefits that he could draw would be $1,000.
Assuming an average weekly salary of $100,
and a WBA of $50, his maximum benefit
duration would be 20 weeks . He would have
had to have worke·d 39 weeks in his base period
11 Strength ening Un employment Insuranc e, pp . 34-35 .
12 In th e remaining eight states , all of which use weeks of
prio r e mpl oyment to determine benefit eligibility, the
durati o n of benefits is determined a s a fraction of the
number of weeks wo rked during th e base period .

(rather than the 30 weeks assumed here) , and
earned $3,900 in order to be eligible for a
maximum of 26 weeks of benefits. Thus,
because the WBA formulas and specified
fractions vary greatly among the states , very
large differences exist in the potential duration
of benefits for given work experience.
EXTENDED,EMERGENCY,AND
SPECIAL BENEFIT PROGRAMS

One result of the variable duration method of
benefit calculation is that in most states a
significant proportion of claimants are entitled
to fewer than 26 weeks of benefits .
Furthermore, depending on economic condition , between one-fifth and one-third of all
beneficiaries exhaust their regular benefit
entitlement each year. 1 3 As is seen in Table 1,
this problem is especially pronounced in
periods of economic downturns. IQ response to
recessionary increases in benefit exhaustions,
Congress enacted in 1958, and again in 1961,
Table 1
EXHAUSTION OF U BENEFITS IN THE
UNITED STATES: SELECTED YEARS

Year

Total
Exhaustees
(millions)

Per Cent of All
Benet ic iari es

1957 ( prerecession)
1958 (recession)

1. 1
2.5

22.7
31.0

1960 (prerecession)
1961 (recession)

1.6
2.4

26.1
30.4

1969 (prerecession)
1970 (recession)
1971 (recession)

0.8
1.3
2.0

19.8
24.4
29.9

SOURCE: Handbook of Unemployment Insurance
Financial Data , U . S. Department of Labor ,
Manpower Administration .
13 Strengthening Un employment Insurance, Table 3, p.
38, and Saul J . Blaustein , Unemployment Insurance
Objectives and Issu es (Kalamazoo : W . E . Upjohn Institute ,
November 1968).

Federa ResPrve Bank of Ka'lsas C•ty

Unemplovrnent Insurance

temporary programs designed to extend the
maximum duration of benefits from 26 to 39
weeks. Then, in August 1970, a permanent
extended benefits (EB) program was enacted as
Public Law 91-373, the Federal-State Extended
Unemployment. Compensation Act.
Under this permanent program, which is
financed equally from state and Federal
unemployment tax revenues, workers who
exhaust their regular UI benefits in periods of
abnorma lly high unemployment are eligible to
receive their regular weekly benefit amounts for
an addit ional period of up to one-half their
prev io u s duration e ntitlemen t. A state is
re i mburse d for one-ha lf of any exte nded
be ne fit s it pays. subject to th e restriction that
th e total duration of regular and ex tended
benefits not exceed 39 weeks. Furthermore,
states with maximum regu lar benefit durations
in excess of 26 weeks may be reimbursed for
one-ha lf of these add itional benefits if they are
paid during a period in wh ich the EB program
is in effect.
The program may be triggered into effect on
either the individ ua l state or the national level.
Na tionally. 1t is triggered "on" by a seasonally
adju sted insured unemployment rate of 4.5 per
cent for 3 consecutive months and is triggered
"o tr· when that rate drops below 4.5 per cent
for J co nsecu ti ve months. 1 4 A state's EB
program goes into effec t when its ow n in su red
unempl oy ment rate (not seaso nall y adjusted)
averages a t least 4 per cent for any 13
consecut ive weeks and exceeds 120 per cent of
its average rate for the same 13-week period in
each of the 2 preceding years. The state
program triggers "off' after a 13-week period
in which either res triction is not satisfied. Once
th is occurs . it ma y not trigger "on" again for at
least 14 weeks. Similarly. because the nati onal
" o n" a nd "off" trigg e rs require specific
un e mpl oyment rates for each of 3 consecutive
14 From Ja nu a ry I . 1975 to March 31. 19 77. states have
th e o ptio n o f choosing a 4.0 per cent nat iona l insured
un e mploy me nt ra te trigger .

months. once national benefits are triggered
"on" or "off' they must remain in that status
for at least 14 weeks. 15

Federal Supplemental Benefits
As unemployment began to climb rapidly in
mid-1974, large numbers of workers exhausted
not only their regular benefits -but their
extended benefits as well. In response to this
rise in unemployment, Congress enacted two
new Ul laws , one to increase the maximum
duration of benefits and one to expand UI
coverage to previously excluded groups of
workers.
The first of these laws, the Emergency
Unemployment Compensation Act of 1974 , was
mod e led a ft er a similar emerge ncy program in
19 7 1. Under s pecified emergency benefit
conditions, the new law provided for the
payment of Federal Supplemental Benefits
(FSB) to persons who have exhausted their
benefit rights under both the regular State and
the Federal-State Extended Benefit programs.
An eligible individual was entitled to receive
emergency benefits equal to his regul ar WBA
for a period of tJP to one-half his regular
benefit duration, but not exceeding 13 weeks .
The emergency unemployment compen sa tion
program went into effect in a state whenever
Federal-state exten ded b e nefit s were also
15 Merrill G. Murray, Th e Duration of Unemploym ent
B en efits ( K a la m azoo: W . E . Upjohn In stitute, Janu ary
1974). pp . 32-33.
Beca use h igh un em ployment ofte n continues for more
than a yea r during a recession , the 120 per ce nt state
trigger requi rement became more and more difficult to
fulfill as the early recession h igh un employ ment was
incorpo rated into the une mployment rates of t he 2
co mp arison years. Due to this unforeseen problem . severa l
states wit h very h ig h . but stea dy. insured un employment
ra tes tri gge red o ut o f their sta te progr ams in late 19 7 1. and
agai n in mid - 1972. In resp o nse to thi s prob lem. Co ngress
acted six time s to waive this trigger requ ireme nt a t the
op ti on o f th e state leg islatures. Curre nt permissio n to waive
th e 120 per ce nt req uireme nt will expire Ma rch JI. 19 77.
Howeve r . fewer th a n half the sta tes have voted to
implemen t t hi s change . See Murray. pp . 39-4 7 a nd
ln /o r111a1io11 Oil U11 e mploy m e111 . .. . pp . 10- 12.

Unemployment Insurance

payable in that state. However, unlike the
regular and EB programs, emergency payments
are financed entirely by the Federal
Government through repayable advances from
Federal general tax revenues to the program's
account in the Federal Unemployment Trust
Fund.
Since the program's inception in December
1974, two major changes have been introduced
by Congress. First , the Tax Reduction Act of
1975 increased the maximum duration of FSB
payments from 13 to 26 weeks, making the
maximum total duration of all benefits an
unprecedented 65 weeks. Later , the program
was changed to its present form by the
Emergency Compensation and Special Assistance Extension Act of 1975. Under this last
act, the FSB program will terminate on March
31, 1977. From January 1, 1976 through that
date, the insured unemployment rate (IUR) in
the individual states determines how

emergency benefits are to be paid according to
a three-tier method. When the IUR in a state
e;xceeds 6 per cent, 26 weeks of emergency
benefits are payable. Should the rate fall to
between 5 and 6 per cent, only 13 weeks would
be payable. Lastly, if the IUR drops below 5
per cent , no more emergency benefits could be
paid. 16 Thus, as the states shift from one tier to
another, they begin to trigger out of the
program, with the last date for filing any claim
being the week of March 20 , 1977.
The Specia l Unemployment
Assistance Program

The second law passed in response to the
rapidly rising unemployment after mid-1974
I 6 The one exceptio n to th ese shifts is th at worken already
receiving emergency benefits would continue to be eligible
for the maximum duration that was in effect before the
shift took place . See Information on Unemployment . .. ,
pp . 13-14.

Chart 1
PH
O:.J SCHEDULE FOR TEMPORARY UI PROGRAMS
Gradual Reduction of Temporary Programs on a State by State Basis
as Unemployment Situation Improves in Each State
(Beginning January 1, 1976)
26

Weeks

Maximum Duration When The
Insured Unemployment Rate Is:

Progroms for Covered Workers

6% o r more i n t he state, for the most
recent 13 w eeks
5% or mor e i n the state, for the most
recent 13 week s
Mor e than 4 .5% (4.0% optional) in
the nation or 4 .0% in the state.
Less than this levei in the nation or
the sta te

lttitttml

Stote -finonced Regul or Unemployment lnsuronce ( 26-week mox1mum)

Federal - State (50 - 50 shared f1nanc1ng ) Extended Benefits (13 - week maximum)

CJ
CJ

Fed eral Supplemental Benefits (100% Federal financing )(l 3 - week maximum)
Amended Federal Supplemental Benefits ( 100% Federal f inancing ) ( 13 - week maximum)

SOURCE : U .S. Department of Labor , Manpower Administration , July 15 , 1975 .

Federal Reserve Bank of Kansas City

Unemployment Insurance

Chart 2
DURATION OF BENEFITS UNDER
PERMANENT AND TEMPORARY
UNEMPLOYMENT BENEFIT PROGRAMS

Maximum Duration of Regular Benefits

Federal-State EB

FSB- Jon. 1975 - Mor. 1977
100% Federal

Weeks

Special Unemployment Assistance
100% Federal General Revenue

Weeks

Maximum Duration of Regular Benefits (State
unemployment insurance laws) : In 41 states , th e
maximum regular duration is 26 weeks , but only 7
of these states provide all elig ib le claimants with
26 weeks; in the other 34 states , potential duration
for a signi ficant proportion of beneficiaries is less
than 15 weeks. Puerto Rico has uniform duration of
20 weeks . Ten states , o ne of which provides all
elig ible claimants with 30 weeks , have regular
maxim um durations exceeding 26 weeks.
Federal-State Extended Benefits (E B) (Fed eral State Extended Unemployment Compensation Act
of 1970) : Permanent program , triggered into
operation by high state or nat ional insu red
une mployment rates . Maxi mum duration is 13
weeks , or 39 total of regular and EB; individ ual
gets half his regul ar duration. In the 9 states with a
regular maximum longer than 26 weeks , the weeks
in excess of 26 paid during an extended benefit
period are financed on a 50-50 bas is .
Federal Supplemental Benefits (FSB) (Emergen cy
Unemployment Co mpensation Act of 1974 , as
amended and extended by sec . 701 , Tax Reduction

Monthly Review • June 1976

Act of 1975, and the Emergency Compensation and
Special Unemployment Assistance Act of 1974):
Temporary 2-year program , triggered by same
insured unemployment rates as Federal-State EB.
Individual durat ion equal to regular duration , not
exceeding 26 weeks. ,Not available after March 31 ,
1977. Subject to triggering off beginning January 1,
1976 , by reason of lower insured unemployment
rate in the state .

Special Unemployment Assistance (SUA) (Title II ,
Emergency Jobs and Unemployment Assistance
Act of 197 4 as amended and extended by the
Emergency Compensation and Special Unemployment Assistance Act of 1975): Temporary 2-year
program of Federal benefits for workers not eligible
for regular state benefits. Benefit amount based on
applying state benefit formula to individual's
employment , disregarding difference between
covered and noncovered work . Maximum d u rat ion
39 weeks . Program ends December 31 , 1976, with
last benefits payable March 31 , 1977 .
SOURCE : U .S. Department of Labor, Manpower
Administration , Unemployment Insurance Service ,
July 15 , 1975 .

Unemployment Insurance

was the Emergency Jobs and Unemployment
Assistance Act. Under Title II of this act, a
temporary program of Special Unemployment
Assistance (SUA) was developed to provide up
to 26 weeks of benefits to unemployed workers
who were not covered by regular Federal or
state UI programs. Funded entirely by Federal
general tax revenues , SUA became operative in
a local area when for 3 consecutive months the
seasonally adjusted national unemployment
rate averaged at least 6.0 per cent, or the
unadjusted local area unemployment rate
averaged at least 6.5 per cent. 11 The program
was designed to trigger "off' when neither
condition was met.
The SUA program expanded coverage to the
approximately 12 million wage and salary
workers employed in state and loc al
government, farming , and domestic work. The

17 A local area is defined as a political entity of over
100,000 population. The unempl oyment rates used as
triggers for SUA are conventional unemployment rates as
opposed to the insured unemployment rate concept used in
all the other programs.

only significant group remaining uncovered was
the self-employed. Benefits were made available
to all former employees meeting the regular
state program ' s employment and earnings
requirements during the most recent 52-week
period (rather than during the state's usual
lagged base period). Any type of wage or salary
employment was treated as covered and benefit
entitlement was the same as under the regular
state program, except that benefit duration
originally could not exceed 26 weeks .
Initially scheduled to expire on December 31,
1975, the SUA program , like that for
emergency benefits, was extended by the
Emergency Compensation and Special Unemployment Assistance Extension Act of 1975
wh ich al o increased the maximum SUA
benefit duration to 39 weeks. The Special
Assistance program will now terminate on
December 31 , 1976, with the last benefits
payable on March 31, 1977. Charts 1 and 2
summarize the important characteristics of the
various UI programs in effect today and their
scheduled phaseout as the un emp lo ymen t
situation improves throughout the nation.

Fec1Pral Reserve Bank of Kansas City

Full text of Economic Review (Federal Reserve Bank of Kansas City) : June 1976

FRASER