An Axios piece warned that recipients of unemployment insurance benefits may receive a smaller tax refund or owe taxes due to a “quirk” in the tax code that counts these benefits as taxable income. In reality, however, the taxation of unemployment insurance benefits is not a “quirk.” It is an application of the simple principle that the income tax system should tax all forms of income neutrally.

Ideally, income tax would be
imposed on all income earned by individuals, including fringe benefits such as
health insurance, life insurance, pensions, and tuition assistance. Unemployment
insurance is effectively a legally mandated fringe benefit that should also be
taxed.

Unemployment insurance is a joint
state-federal program that provides wage replacement for workers who lose their
jobs. “Premiums” are paid by employers on workers’ behalf in the form of
employer-side payroll taxes. When a worker loses their job, they can apply for
unemployment insurance benefits. The level of taxes and benefits differ by
state.

Under current law, as established
by the Tax Reform Act of 1986, the tax treatment of unemployment insurance is consistent
with some other forms of non-cash compensation offered by employers, such as
disability insurance. The premium (or tax) paid by the employer is not added to
the employee’s taxable income when paid. Instead, the insurance is taxed when
the employee receives the benefit.

Excluding certain forms of compensation from taxation creates a preference for different forms of income. Taxpayers who earn the same amount of income, but have different forms of compensation, would face different effective tax rates. Prior to the taxation of unemployment benefits, there were also concerns that taxing wages, but not unemployment benefits, could discourage labor force participation.

Recently, there was some concern that low-income households receiving enhanced unemployment insurance benefits in 2020 may see a lower refund due to how the Earned Income Tax Credit (EITC) is calculated. This interaction is more of a complex quirk with the EITC than unemployment insurance. The problem is that the EITC does not count unemployment insurance as the EITC is phased in but it is counted as the EITC phases out. In other words, unemployment insurance can only reduce EITC payments. However, this issue was addressed by Congress in the year-end coronavirus relief law by allowing taxpayers to use 2019 income, rather than 2020 income, to compute their 2020 EITC if it resulted in a larger EITC, thereby providing relief to taxpayers who received unemployment benefits in 2020.

Although receiving unemployment insurance may impact tax refunds at the end of the year, lawmakers were correct to fully subject unemployment benefits to taxation.

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