Another hit to states: Interest payments to Uncle Sam

NEW YORK (CNNMoney.com) -- The Great Recession has forced states to borrow $41 billion from a federal fund to cover unemployment checks for their jobless residents.

Now the bill is coming due.

Some 31 states will have to shell out an estimated $1.4 billion in interest payments on these loans next year. They had been spared this expense because of an obscure provision of the 2009 Recovery Act that expires on Dec. 31.

The burden to cover this cost will fall mainly on businesses, who will see their unemployment taxes rise. But states will be hit too since the increased expense will likely deter companies from hiring new employees.

"To escape the recession, we need economic recovery," said Rochelle Webb, the president of the National Association of State Workforce Agencies and head of Arizona's unemployment insurance system. "If local employers are facing increased taxes, they are going to say they can't afford to expand their businesses."

Some states might also have to cover at least part of the payment from their general revenues, a step they can ill-afford since many are facing hefty budget deficits.

As a result, state officials and employers are lobbying Congress to extend the interest-free borrowing provision in the stimulus package for another two years.

Here's how states got in this situation:

States use taxes from employers to pay 26 weeks of jobless claims. But the tax revenue hasn't kept up with the huge spike in unemployment, forcing many states to borrow from the federal unemployment trust fund.

To pay the federal fund back, states have been raising taxes on companies. Two dozen states hiked such levies in 2010 and more are looking to do so again in 2011.

But the interest payments on the federal loans cannot be paid from these standard unemployment taxes. Some states have automatic "solvency" taxes that kick in. in others, lawmakers are wrestling with how to cover the tab -- at a time when budget shortfalls are already a problem.

It's common for states to borrow from the federal trust fund and the loans can be repaid over several years. But states have never had to rely on the federal fund as much as they are now, said Andrew Stettner, deputy director of the National Employment Law Project, an advocacy organization.

During the 1980s recession, states only took out $28 billion, on an inflation-adjusted basis. And the problem will only get worse. The U.S. Labor Department estimates borrowing could grow to $65 billion by fiscal 2013 and some 35 states could be in the hole.

"It's another major fiscal challenge states have to grapple with as they rebuild their finances," Stettner said.

The law project is concerned that states will start cutting benefits so they don't have to keep raising taxes on businesses. In the 1980s, more than 40 states reduced payments and eligibility.

States are girding for the looming interest bills.

Texas plans to issue up to $2 billion in bonds to wipe out its $1.5 billion loan before it must make an interest payment. The funds will also go to replenishing the state account.

The Lone Star State sold $1.2 billion in bonds last week with an effective interest rate of about 2.39%, which would be paid by employers. The current rate being charged by the Labor Department is 3.9%.

By issuing bonds, Texas will lessen the blow to businesses, which already saw the state's minimum unemployment tax levy go up 177% this year, according to Ann Hatchitt, spokeswoman for the Texas Workforce Commission. The estimated interest payment on the loan would have been $46.5 million.

"It's part of a long-term plan to minimize taxes on employers," she said.

In Michigan, some companies will be socked with a maximum annual solvency tax of $67.50 per employee starting Jan. 1. That's on top of the regular unemployment tax, which averaged $477 per employee in 2009, the latest figure available.

"This is a bad time for additional costs on the employer community, who should focus on job development," said Stephen Geskey, who heads the Michigan Unemployment Insurance Agency, which has borrowed $3.8 billion.

Even worse, the Michigan solvency taxes may not be enough to cover the state's interest payments, estimated at $111 million, Geskey said. So the state legislature, which will have to contend with a budget gap of at least $1.5 billion, could have to decide how to come up with the remaining money.

California, which is facing the largest estimated interest payment of $362 million on a loan of $8.8 billion, has not yet determined how it will pay the tab. The state Employment Development Department updates lawmakers on a monthly basis, but they are busy resolving an estimated $25 billion budget hole.

Whatever happens, businesses in the Golden State will have to pay more to keep the unemployment insurance system afloat.

"Employers are looking at increased taxes one way or another," said Loree Levy, a department spokeswoman. "It will be a tough situation for quite some time."