During the pandemic, implementation problems in some states resulted in income tax not being withheld for many unemployed workers due to higher unemployment benefits and surprising tax burdens. For example, in California, when workers chose to withhold 10 percent of their unemployment benefit for taxes, it was only for state benefits, not for improved federal benefits. The American Rescue Plan Act (ARPA) exempted workers earning less than $ 150,000 by excluding the first $ 10,200 of unemployment benefits received in 2020 from income taxes.
At the time of the temporary exclusion, more than 55 million tax returns had already been submitted. Chuck Rettig, Commissioner for the Internal Revenue Service (IRS), has indicated that the IRS may be able to automatically issue refunds related to the exclusion rather than requiring taxpayers to file amended returns. Taxpayers must await final guidance from the IRS on exclusion.
Since 1987, unemployment benefits have been subject to federal income tax and, in most federal states, to state income tax. According to the Congressional Research Service, such treatment – including unemployment benefits in taxable income – is common in all developed countries.
The reasons for including unemployment insurance in taxable income are obvious: the income tax system should treat all types of allowances neutrally. Exclusion of one type of compensation from tax can lead to different effective tax rates in similarly located households and create a preference for untaxed compensation. Unemployment insurance is a form of income – similar to a fringe benefit such as health insurance or study allowance – that, like other forms of income, should be included in the tax base.
Prior to 1979, government unemployment benefits were not included in the tax base. However, unemployment benefit received under a private plan was taken into account when it exceeded an individual’s contribution. In the Revenue Act of 1979, Congress made some government-provided unemployment benefits taxable for taxpayers earning above a certain basic income level. The Joint Tax Committee explained the reason for the change because Congress believed
“These benefits are essentially a substitute for taxable wages and are equivalent to unemployment benefits paid under private plans that are included in gross income if they exceed the recipient’s previous contributions. Congress also believes that prior total exclusion from unemployment benefits paid under government programs tended to result in an incentive to work as it created the incentive to remain unemployed, the length of unemployment, and the resulting cost of maintaining it unemployment insurance increased. Therefore, for taxpayers with significant other income during the year, the law is subject to income tax on part of the unemployment benefit. “
Concerns about incentive effects, such as whether unemployment benefits reduce incentives to find a new job, stems in large part from the work of economist Martin Feldstein, who argued that unemployment benefits increase unemployment because it creates incentives for longer terms and temporary jobs or seasonal patterns of employment. One of his several proposed corrections to the unemployment system was to include unemployment benefit in the income tax base.
In 1981, Congress increased the amount of taxable unemployment benefit by lowering the basic income for exclusion, mainly to increase income for longer benefit periods. In 1986, Congress made unemployment benefits fully taxable, along with other changes in tax law that lowered marginal tax rates and expanded certain tax credits.
The Congressional Research Service states that the taxation of unemployment benefits “puts all unemployment benefits on the same footing as wages and other ordinary income for income tax purposes. Although this move reversed the original policy of taxing UC benefits only above an AGI threshold, it came under a law that removed many low-income applicants from the tax list. “Subsequent changes required states to notify recipients of their tax liability and to provide the option to withhold income tax from their unemployment benefit.
The American Rescue Plan Act’s exclusion from the first $ 10,200 in unemployment benefits for certain workers is similar to the one-year $ 2,400 exclusion from unemployment benefits set out in the 2009 American Reinvestment and Recovery Act. The best argument for the exclusion of the American Rescue Plan Act is the implementation problems in state withholding tax systems, which led to surprising tax burdens. Along with two cases of one-year exclusions that have resulted in significant economic downturns, unemployment benefits have been taxable since 1987 and this is the appropriate tax treatment.
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