# Chapter 11

```CHAPTER
11
Social Security
McGraw-Hill/Irwin
Social Security Expenditures
(1939-2007)
Source: Social Security Trustees [2008].
11-2
Why Have Social Security?
• Consumption Smoothing and the Annuity
Market
– How Social Security works
– Annuity
– Consumption smoothing
• Adverse Selection and the Annuity Market
– Asymmetric information
11-3
Other Justifications
• Lack of foresight and paternalism
• Moral hazard
• Economize on decision-making and
• Income Redistribution
• Improve the Economic Status of the Aged
11-4
Fully Funded Plan
Period 1 Period 2 Period 3 Period 4
The Greatest
Generation
Work
contribute
The Baby Boom Childhood
Generation
Generation X
Unborn
Retire
Each generation’s
benefits
benefits based on
deposits it made during
Retire
Work
working life plus
accumulated interest
contribute
benefits
Childhood
Work
contribute
Still
Retire
benefits
11-5
Pay As You Go (or Unfunded)
System
Period 1 Period 2 Period 3 Period 4
benefits
The Greatest
Generation
Work
Retire
contribute
benefits
The Baby Boom Childhood
Generation
Generation X
Unborn
Work
Each generation’s
Still
benefits come from
tax
current workers
Retire
contribute
benefits
Childhood
Work
Retire
contribute
benefits
11-6
Today’s Partially Funded System
Period 1 Period 2 Period 3 Period 4
benefits
The Greatest
Generation
Work
contribute
The Baby Boom Childhood
Generation
Generation X
Unborn
Baby Boomers
and Gen X are
Retirealso
contributing to
their own
benefits
retirement
Work
Retire
Still
contribute
benefits
Childhood
Work
Retire
contribute
benefits
11-7
Explicit Transfers
• Benefits for dependents and survivors (1939)
• Supplemental Security Income
11-8
Benefits
• How to calculate benefits
– AIME (Average Indexed Monthly Earnings) –
average monthly earnings in 35 highest paid years
• Wages indexed for inflation
• Ceiling on AIME – up to tax ceiling
11-9
Benefit Structure
If AIME &lt; \$711 PIA = .90*AIME
If \$711&lt; AIME &lt;\$4288  PIA = .90*\$711 + .32*(AIME - \$711)
If AIME &gt; \$4288  PIA = .90*\$711 + .32*(\$4288-\$711) + .15*(AIME - \$4288)
\$2,500
First
Break
Point
\$2,000
\$1,500
Second
Break
Point
\$1,000
\$500
\$0
\$0
\$1000 \$1500 \$2000 \$2500 \$3000 \$3500 \$4000 \$5000 \$5500
11-10
• Annual inflation adjustment
• Age at which benefit is drawn
– Normal retirement age
– Early retirement – benefit reduced 5/9th of one
percent a month for first 36 months preceding
normal retirement age
– Late retirement – benefit increased 8% a year
11-11
• Family Status
– +50% for spouse or dependent child
– If covered worker dies spouse receives 100% of worker’s benefit
or spouse’s own benefit (whichever is higher)
– Divorced spouse married at least 10 years gets spouse benefit if
not remarried while covered worker alive
• Earnings test and taxing benefits
– Benefits reduced \$1 for every \$2 earned above \$14,160
– Individuals losing benefits may have later benefits increased
– Up to 85% of benefits taxed for recipients with income above a
base amount (\$25,000 for single and \$32,000 for married
taxpayers.)
11-12
Financing
• FICA (Federal Insurance Contribution Act)
• 2008 Social Security Tax rates
– Employee
– 6.2% (OASI - 5.6%, DI - .6%) of first \$102,000 of earnings on
both employee and employer
– Self-employed
• 12.4%
• 2008 Medicare Tax rates
– 1.45% on both employer and employee with no earnings ceiling
• Why not fund Social Security through general tax revenues?
11-13
Distributional Issues
• Actuarially fair return
• Intergenerational redistribution
– Total benefits = Nb * B
– Total taxes = t * Nw * w
– If total benefits = total taxes:
Nb * B = t * Nw * w or
B = t * (Nw/Nb) * w
• Ida Mae Fuller
11-14
Ida Mae Fuller
11-15
Single Male
400
All values expressed in 2006
dollars.
High
Max
-600
-800
-1000
Year Cohort Turns 65
One-earner Couple
Tw o-earner Couple
400
400
200
200
0
Low
-200
Average
High
-400
Max
-600
0
Average
-200
High
Max
-400
-800
-600
-1000
-800
Year Cohort Turns 65
Low
19
40
19
60
19
80
20
00
20
20
20
40
20
60
See C. Eugene Stueuerle and
Jon M. Bakija [1994] for
original tables and
methodology.
Average
-400
Thousands of 2006 Dollars
Source: Updated tables,
furnished by C. Eugene
Steuerle and Adam Carasso,
2006.
Low
-200
19
40
19
60
19
80
20
00
20
20
20
40
20
60
Representative
Individuals
0
Thousands of 2006 Dollars
Social
Security
Wealth:
Thousands of 2006 Dollars
200
Year Cohort Turns 65
11-16
Other Distributional Issues
• Redistribution within a generation
–
–
–
–
Differences by earnings
Differences by lifespan
Differences by living arrangements
Differences by number of earners in the family
• Normative evaluation
11-17
The Social Security Trust Fund
Worker
Trust
Fund
Retiree
• Social Security and National Saving
• Budget Treatment of Social Security
– Off budget
– Unified budget
11-18
Social Security and Savings
Behavior
•
•
•
•
Life-cycle theory of savings
Wealth Substitution Effect
Retirement Effect
Bequest Effect
11-19
Future consumption (c1)
Budget Constraint for Present and Future Consumption
N
D
(1+r)S
I1 + (1+r) S
At endowment
point consumer
neither saves nor
B borrows
I1
(1+r)B
F
S
I1 - (1+r) B
M
I0 - S
I0
Present consumption (c0)
11-20
Future consumption (c1)
Utility-maximizing Choice of Present and Future
Consumption
N
c1*
E1
A
I1
Saving
c0*
I0
M
Present consumption (c0)
11-21
Future consumption (c1)
Crowding out of private saving due to Social
Security
N
E1
c1*
R
A
I1
(1+r)T
TSaving after
Saving before
Social Security
Social Security
M
c0*
I0T
I0
Present consumption (c0)
11-22
Empirical Evidence: Does Social Security
Reduce Saving?
• Time-series evidence
– Martin Feldstein (1974, 1996) v Leimer and
Lesnoy (1982)
• Cross-section evidence
• Evidence from other countries
– Attanasio and Brugiavini (2003) and Italy
11-23
Other ways Social Security Affects Saving
• Retirement effect
• Bequest effect
• Empirical evidence
11-24
Distribution of Wealth
• Bequeathable vs. Annuitized Wealth
• Effect of Social Security on Bequeathable
Wealth
• Effect on Wealth Mobility
11-25
Retirement Decisions
• Social Security wealth and the retirement
decision
• Empirical evidence
– Diamond and Gruber [199]
– Gruber and Wise [2004]
11-26
Long-Term Stresses on Social
Security
Projected revenues and projected costs of Social Security as share of Gross Domestic Product
Source: Social
Security Trustees
[2006]
11-27
Long-Term Stresses on Social
Security
Since: B = t * (Nw/Nb) * w
Rearrange: t = (Nw/Nb) * (B/w)
Dependency Ratio
Replacement Ratio
11-28
Social Security Reform
• Time horizon for solvency
– Sustainable solvency
11-29
Maintain the Current System
•
•
•
•
•
•
Raise the payroll tax
Raise the Maximum Taxable Earnings Level
Raise the Retirement Age
Reducing the Cost-of-Living Adjustment
Change the Benefit Formula
Comparing the Options
11-30
Privatize the System
• Personal Accounts
• Pros and cons of personal accounts
– Effect on Solvency
– Effect on Saving
• Carve-out accounts