The silent job killer: Our unemployment system

July 19, 2012, 5:56 PM UTC

FORTUNE — Hemingway Apparel, located in a rural former cotton town a hundred miles east of South Carolina’s capitol, should be the kind of small business that government nurtures. In a county where the unemployment rate hovers near 12%, the factory employs low-skilled workers who don’t have a lot of options.

Hemingway barely survived the drift of apparel production overseas. Today, company owner Jack L. Marsh benefits from the “Made in America” determination of top customer Angela Newnam.  The Harvard Business School grad and former McKinsey consultant also happens to be a daughter of the Carolina textile mills who is putting her company, Knockout Panties, behind her stubborn belief in American manufacturing.

The Marsh-Newnam partnership has all the makings of a grassroots business story that — stitched with thousands of others — could aid an American jobs revival. Except for one thing: Marsh isn’t hiring. He’s being killed by unemployment taxes that are on their way to quadrupling since 2009. When new business comes calling, Marsh says, “I have to ask myself if there’s another way to meet production needs without adding employees.’’ He would rather pay overtime than shell out a per-worker tax of $900 (up from $270 three years ago) that is slated to rise to about $1,100 in 2014.

While Fortune 500 executives regularly complain that “uncertainty” over taxes and other government policies is holding back hiring, small businesses face a grim certainty — their costs of doing business are definitely going up. Now that the Supreme Court has upheld the Affordable Care Act, companies with more than 50 employees will be required to offer health insurance or pay a fine, potentially discouraging expansion.

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After four years with a U.S. jobless rate hovering above 8%, states have run out of money. They’ve borrowed from the federal government, and are now raising taxes on business. So unemployment taxes, which is essentially an insurance system meant to provide a temporary cushion for laid-off workers, is actually impeding the creation of jobs that would help them get back into the workforce.

Between 2008 and 2011, $174 billion in unemployment taxes was collected while $450 billion was paid out in benefits, a gap of $276 billion. Thirty-four states blew through their unemployment insurance trust funds and borrowed from Washington — and 22 of those still owe the feds a total of more than $30 billion, according to the Tax Foundation. The foundation’s study concluded that some states will not fully repay those loans for years.

Hemingway Apparel factory in Hemingway, S.C.

The unemployment benefits system was built on a combination of wishful thinking, generosity, and skimpy funding during good times. In the first quarter of 2008, just before the recession hit, only 17 states had sufficient reserves to cover a year of benefits — and 20 states couldn’t even cover half a year, according to Tax Foundation calculations.

The new costs of hiring come just as the National Federation of Independent Business has published a gloomy survey of small companies showing negative job creation and pessimism about the future. “There was no good news in the June survey” released last week, the trade association said. “NFIB members didn’t add a lot of jobs and don’t plan to in the coming months.”

A combined 40% of those surveyed cited “taxes” and “government regulation/red tape” as the most important problems facing small business, compared with 23% who cited “poor sales.” That’s a pretty loud shout to lawmakers.

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Higher unemployment taxes have been particularly bruising for small businesses that have had a history of struggles like Hemingway, which had to downsize when a major client moved its production operations to Honduras in 2009.

While South Carolina businesses with no past unemployment claims will see a tax reduction, businesses with a history of layoffs — about a third of them in this state, where unemployment is still over 9% — face job-crippling increases ranging from 100% to 600%.

Early on in the recession, Congress voted to extend unemployment benefits for jobless workers to 99 weeks. That extra money came from Washington, rather than the states, so the state tax hikes on business can’t be traced directly to the vote.

But that vote, and others since, prompted the beginnings of a debate over whether the unemployment insurance system needs a major overhaul. A number of academic studies suggest that extending benefits creates a “moral hazard” in which beneficiaries postpone serious job searching. That, in turn, contributes to a higher unemployment rate.

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Critics of the current system also call for giving states more flexibility to create programs to help people get back to work. And clearly, a funding mechanism that still discourages small businesses from hiring — more than three years after the recession officially ended — needs review.

Meanwhile, Jack Marsh, the Hemingway Apparel owner and a critic of free trade agreements, is optimistic that some U.S. producers that fled offshore will return in search of better quality and that popular “Made in America” label. Already, a sleepwear maker has returned to South Carolina from China.  “We’re seeing a lot of people looking to make their apparel in America,” Marsh says.

Let’s hope that when they do come knocking, he’ll be inclined to hire more workers to get the job done.