Question

Unemployment benefits are subject to income taxes. They are not (by default) subject to withholding, or to payroll taxes. Suppose that a particular worker is subject to a payroll tax of 7.65% of her wages; that she pays an average income tax rate of 10%; and that after losing her job, she is eligible to receive 60% of her previous weekly income. (Show Work)

(a) What fraction of her take-home paycheck will she receive from unemployment insurance?

(b) What effect does the tax treatment of unemployment insurance benefits have on the ability it provides its recipients for smoothing?

Answer 1

a) Let the gross income of an employee be x before unemployment.

After deducting income tax and payroll tax, the net income of the employee is:

x - 0.1 x - 0.0765 x = 0.8235 x

After unemployment, the gross allowance received by the person = 0.6 x

After deducting income taxes, the net allowance received = 0.6 x - 0.06 x = 0.54 x

The fraction of the take home paycheck received by the worker = 0.54x/ 0.8235 x = 0.65

Therefore, he receives 65% of his paycheck as allowance.

b) The payroll tax is deducted from the income of the employees in order to pay for unemployment allowance and social security of others who have lost employment or are unable to work. An employee while in employment can afford to pay a part of his income as payroll taxes and if he loses employment he receives unemployment allowance from the fund of payroll taxes of working employees. In this manner, every worker is able to sacrifice some of his consumption in the form of payroll taxes so as to be able to consume during periods of unemployment. This kind of funding of unemployment allowance out of workers paycheck enables them to smooth their consumption across periods of employment and unemployment by uniformly distributing the consumption.