Chapter 11 Notes
I. PRINCIPAL FEATURES OF SOCIAL SECURITY
A. Definitions and General Comments
1. The term Social Security is used in this text to refer to the old-age and survivors' insurance
program (OASI) administered by the Social Security Administration. In its broadest sense,
Social Security refers to all social insurance programs established by the Social Security Act.
2. OASI was financed in 2000 by a payroll tax equal to 10.6 percent on earnings up to $80,400.
3. Employers "pay" one-half of the OASI tax and employees "pay" the other one-half (Note: the
actual incidence is examined in the section; Who Pays the Social Security Tax).
B. Social Security Payments
1. Social Security is primarily financed on a pay-as-you-go basis, unlike private insurance,
which is fully funded.
a. In a pay-as-you-go insurance plan, the fund has a balance that can cover future benefits
and expenses for only a short period of time.
b. A fully funded insurance plan has a fund that can cover future benefits and expenses for
many years.
2. Social Security provides periodic benefit payments based on earnings averaged over most of
a worker’s lifetime.
a. Benefits are determined by “indexing” the earnings before age 60 to account for changes
in average national wages in the same period.
b. Social Security adds the 35 years of highest indexed earnings and divides this amount by
420 (the number of months in 35 years) to determine the average indexed monthly
earnings (AIME) to which it applies a formula to arrive at the basic benefit, or primary
insurance amount (PIA).
c. PIA is the amount a person would receive at the normal or full retirement age, which
varies between 65 and 67.
3. PIA/AIME ratio falls as income rises since the Congressional intent was to deliberately
provide a safety net for elderly poor.
4. It is estimated that 45% of elderly would fall below poverty line in absence of Social
Security, however, in 1998, poverty rate for elderly (10.5%) was below the poverty rate for
the population as a whole (12.7%).
5. Social Security is indexed to Consumer Price Index (CPI)
6. Workers who delay retirement beyond age 65 receive, from Social Security, a delayed
retirement credit of 8% up to age 70.
7. Income from Social Security is treated more favorably in the federal tax code than is income
from private retirement insurance.
II. WHO PAYS THE SOCIAL SECURITY TAX?
A. A 10.6% tax is levied on taxable payroll. Employers collect half through a payroll reduction and
remit the full amount to the federal government.
B. How Much of the Tax Do Workers Pay?
1. The shape of the labor supply curve depends on two effects.
a. The substitution effect of a wage decrease says that when the hourly wage decreases, the
opportunity cost of leisure time decreases. Workers substitute more leisure time for
fewer hours worked.
1. Declining wages mean fewer hours worked
2. This can create a positively sloped labor supply curve.
b. The income effect of a wage decrease says that since wages have fallen the worker needs
to work more in order to maintain his or her income.
1. Declining wages mean more hours worked.
2. This can create a negatively sloped labor supply curve.
c. If neither effect dominates, the labor supply curve is vertical.
2. In the case of a vertical supply of labor curve, where a change in wages has no impact on
hours worked, employers are able to shift the entire burden of the tax on to the workers
without causing a loss of hours worked.
3. In the case of a positively sloped supply of labor curve (where the substitution effect
dominates), the lower wage rate due to the tax will reduce hours worked. Employers cannot
shift the entire burden of the tax on to the workers. They share the burden.
4. Which interpretation is correct?
a. Congress probably assumed that employers and employees would share the burden of the
tax.
b. Evidence tends to favor a supply of labor curve that is vertical, or nearly so, which
implies that workers pay most of the tax.
III. SOCIAL SECURITY AND EARLY RETIREMENT
A. Labor Force Participation Rate
1. Labor force participation rate is the percentage of a certain population in the labor force.
2. For men 65 and over, it has fallen from 41.4% to less than 15 %.
3. This trend is due to various factors including higher incomes, private pension plans, changing
lifestyles, and Social Security.
B. Decreased labor force participation by men over age 65 was an early goal of the Social Security
program.
1. Older workers left the labor force and made room for younger workers who were having
trouble finding work during the Great Depression.
2. Today, early retirement is a problem.
a. It reduces labor supply and potential output.
b. It hastens the long-run Social Security deficit.
3. Early retirement penalties just make up for the extra years during which early retirees will be
drawing benefits. Total lifetime Social Security benefits are unchanged by the penalty.
IV. SOCIAL SECURITY AND HOUSEHOLD SAVING
A. Social Security May Decrease Savings
1. If Social Security decreases savings, private investment, and hence GDP, will be smaller.
2. Social Security may decrease savings because of the wealth substitution effect.
a. The wealth substitution effect induces workers to substitute Social Security wealth for
other types of wealth that could be financed by savings.
B. Social Security May Increase Savings
1. If Social Security increases savings, private investment, and hence GDP, will be larger.
2. The induced retirement effect may induce people to save more.
a. The induced retirement effect refers to Social Security's tendency to encourage people to
retire at an earlier age.
b. Greater savings will be necessary to finance the longer retirement period.
3. The bequest effect may induce people to save more. The bequest effect refers to the tendency
of Social Security to induce working people to increase their saving so as to increase the
bequest they leave their children.
C. Evidence: Social Security and Its Effect on Savings
1. Martin Feldstein found that over the period 1930 - 1992, the wealth substitution effect
dominated.
2. Over this period, a $1.00 in Social Security wealth was associated with a decrease in savings
of $.028. This is equivalent to a $392 billion reduction in saving, and would indicate that
Social Security has a negative impact on the capital stock, and hence, economic growth.
3. Other studies have produced results ranging from a positive effect to a negative effect only
one-sixth the size of Feldstein's.
V. INDIVIDUAL RATES OF RETURN
A. Rates of Return Based on Monetary Benefits and Costs
1. The real rate of return on Social Security for a typical person born in 1982 who enters college
in fall 2000, at age 18, graduates in 2004, and works until age 67 is only about 1.24%.
2. If the student/worker's best alternative is the 2% real rate of return earned historically on
long-term government bonds, the investment made in Social Security is not worth it.
3. If the student/worker bears the burden of only the half of the Social Security payroll tax that
is deducted from the paycheck, the real rate of return would increase to 3.48%, which is much
better than 2%.
VI. IS THAT ALL THERE IS TO IT?
A. Rates of Return Adjusted for Nonmonetary Benefits
1. There are 3 principal nonmonetary benefits.
a. Protection against income risk
b. Protection against inflation risk.
c. Protection against post-retirement poverty.
2. In summary, the real rate of return from an investment in Social Security retirement program
is likely to be closer to 5% than 1% estimated above.
VII.
THE LONG-RUN DEFICIT
A. What Social Security Analysts Say
1. Alternative I is the most optimistic projection of Trust Fund surpluses.
2. Alternative III is the most pessimistic projection.
3. Alternative II is considered the “best projection.”
a. The OASI Trust Fund should have a growing surplus for another 20 years.
b. By 2017, annual expenditures will begin to outweigh annual receipts.
c. By 2041, the Trust Fund will be exhausted.
B. Are The Analysts Right?
1. Two variables in the creation of the above alternatives are widely debated.
a. Fertility Rates
1. The “best projection” assumes a fertility rate of 1.9.
2. The likely impact of higher fertility rates on the Trust Fund deficit would be small.
b. Rate of Increase in real gross domestic product (GDP)
1. Social Security analysts expect GDP growth rate of 1.8% for the next 75 years.
2. According to data in the 1999 report, a 3% annual growth rate of GDP would
eliminate the long-run imbalance in the Trust Fund. Policies to increase real GDP
growth should be on the list of options for fixing the long-run Social Security deficit.
VIII. WHAT CAN BE DONE ABOUT THE DEFICIT
A. Benefit Reductions
1. A reduction in benefits, starting now.
2. A reduction in benefits, starting after OASI Trust Fund assets are exhausted.
3. The use of a more accurate measure of inflation to index benefits.
4. A change in the method used to index the pre-retirement earnings of middle- and
upper-income retirees.
5. An increase in the normal retirement age.
B. Use a more accurate measure of inflation to index annual retirement benefits.
C. Change the method of indexing pre-retirement earnings of middle-and upper-income retirees.
D. Increase the normal retirement age.
E. Revenue Increases
1. An increase in taxes, starting now.
2. An increase in taxes, starting after OASI Trust Fund assets are exhausted.
3. An increase in investment, financed by the Social Security surplus.
4. The privatization of Social Security
5.
IX. THE TRADEOFF FOR INDIVIDUALS: LOWER DEFICITS MEAN LOWER RATES OF
RETURN
A. Calculations of the rate of return, above, reflect the unstated assumption that the long run deficit
problem will be solved without imposing additional taxes on, or reducing the benefits of, our
typical college graduate. This is unlikely to be the case.
B. Our typical graduate will be expected to pay his or her share of the costs associated with the
options just discussed. This will lower the rate of return.