Chapter 9

Social Security

1

Why Social Security is Needed?

• Externalities
• market, left unregulated, will create impacts on people other than the buyer or seller
• Workers may make a decision to rely on welfare and not save. That decision affects taxpayers.
• People cannot overcome a poor decision not to save
• Most decisions that adversely affect people can be changed.
• The decision not to save cannot be reversed (because you cannot go back and live your life over again.)

Social Security’s History

• The 1935 Social Security Act
• Part of the FDR “New Deal”
• Intended to be a “third leg” of retirement tripod
• Social Security
• Individual Savings
• Company Pensions
• An entitlement
• Social Security Act of 1983
• Created trust fund to fund baby boomer retirements
• Raised retirement age
• Taxing social security benefits

Changes to Social Security

• Tax Rate
• 1935 1%; 2007 7.65% (6.2% plus 1.45% for Medicare)
• Maximum Taxable Earnings
• 1935 $1000; 2017 $127,200 (at the 6.2% rate and unlimited at the 1.45% rate).
• Retirement Age
• Born 1935 or earlier: 65 years of age
• Born 1936 to 1959: Gradual increase in full retirement age
• Born 1960 or later: 67 years of age
• Coverage
• 1935 Old age; 2007 Old age + Medicare + Disability + Survivor

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How to Fund a Retirement System

• Every retirement system must be funded by using currently generated money to pay current retirees OR use the balances of previously saved money to pay current retirees.
• Pay-as-you-go : a system where current workers’ taxes are used to pay pensions to current retirees
• Fully-Funded: system where for every benefit dollar it is required to pay in the future there is an off-setting amount currently invested that is sufficient to pay off that dollar

Social Security Taxes and Benefits

• 2017 tax rate
• Total payroll tax rate = 7.65%
• 6.2% for Social Security
• 1.45% for Medicare
• Both workers and employers = 15.3%
• Self employed pay 15.3%
• Social security tax rate is regressive
• 2017, tax base
• Social Security tax base
• The first $127,200 of each worker’s annual earnings
• Medicare tax base
• All of the worker’s earnings

Effects of the social security tax on two hypothetical high- and low-income people in one year

Social Security Taxes and Benefits

• Social Security retirement benefits
• Qualify: fully insured worker / dependent
• Benefit amounts
• Prior Social Security tax contributions
• Progressive
• Low-earnings workers: higher replacement rate
• Higher-income earners
• Higher Social Security benefits
• Smaller replacement rate
• Replacement rate
• The percentage of the worker’s last working year’s earnings that is replaced by Social Security retirement benefits.

The Problem

• Long-run problem: an aging population
• Average age of population is increasing
• Fewer workers paying taxes
• More retirees receiving benefits
• More workers are retiring at earlier ages
• Longer periods of retirement
• Do not pay Social Security taxes
• Receive benefits
• Baby boomers (1946 to 1964)
• Reason for creation of trust fund

The Problem

• Social Security: pay-as-you-go system
• 1950, 16.5 workers paid Social Security taxes for every Social Security beneficiary
• 2014, 2.8 workers paid taxes for each beneficiary
• 2033, expected 2.1 workers per beneficiary
• Implications
• Unsustainable
• Taxpayers must pay higher taxes, or cut benefits, or find another funding source

The Problem and the Response

• Efforts to address the problem (1983)

To increase the normal retirement age

• Born before 1938: 65 years
• Born after 1959: 67 years

To begin building up trust fund accounts to take care of the increase in benefits expected when the baby boomers retire

• Born before 1938: 65 years
• Baby Boomers: large cohort born 1945-1965
• Began retiring in 2010

To begin to tax a portion of Social Security retirement benefits for income tax purposes

• Benefits originally untaxed
• A person usually pays a tax on 50% of their benefits if combined income >$25,000

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The Problem and the Response

• Long-run financial viability of social security
• The 2017 trustees’ report: the trust funds
• Will continue to be built up until 2021, and then begin to be drawn down
• Exhausted in 2034 (tax revenues will cover 77% of benefits)
• Return to a pay-as-you-go system resulting in
• Higher Social Security taxes,
• Decreased retirement benefits, and or
• Increased government borrowing

Other Issues and Problems

• Should Social Security be made voluntary?
• Arguments
• Greater economic freedom
• Limitation of government’s role in our lives
• Fairness of the Social Security system to younger workers
• A voluntary program would make provision of a minimum level of economic security to the entire population more difficult
• The poor could not afford to purchase private insurance or save to provide for their own economic security
• A voluntary system would be subject to greater adverse selection
• A process by which insured people’s choices lead to higher-than-average loss levels for the program’s sponsor

Who Benefits from the Program?

• Based on a present value approach, people who retired before 1980 received, on average, more than they would have in private alternatives.
• People who retired between 1980 and 2000 received ______ than they would have in private alternatives
• More (if they were poor)
• Less (if they were wealthy)
• People who retire today will receive less than they would have in private alternatives.

Using Present Value

• To compute the value of Social Security to an individual, a person would
• Use a reasonable low-risk real rate of interest (3-5%)
• Compute the present value of expected Social Security taxes to be paid.
• Compute the present value of expected Social Security benefits to be received.
• Subtract the present value of costs from the present value of benefits to get the net present value.
• A single worker beginning today can expect a negative net present value.

Other Issues and Problems

Does Social Security decrease savings?

• Incentive to work (lower)
• People retire earlier than they otherwise would have.
• People work less that they otherwise would have.
• Incentive to save (net effect is lower)
• Asset Substitution Effect: government is saving for you, you will save less for yourself (-)
• Induced Retirement Effect: because people need to save more if they are going to retire earlier than they would have without Social Security (+)
• Bequest Effect: increases national savings because people save more so as to give larger gifts to their descendants (+)

Other Issues and Problems

• Social Security’s treatment of women/spouses
• Widow’s income gap
• Monthly survivorship benefits
• Until the youngest child reaches the age of 16
• Again at the age of 60
• Benefits will be lost if the surviving spouse remarries before reaching the age of 60
• Surviving children—entitled to benefits until they reach the age of 18
• Possible unfair treatment of working wives
• Receive the highest retirement benefits
• Based on own earnings, or spousal benefits
• Some wives—never worked outside the home
• Spousal benefits
• Some wives—larger spousal benefits than benefits based on own earnings, but they must select just one of the two.

Other Issues and Problems

• Do other countries face similar problems?
• World’s 65-and-older population
• Will triple by midcentury to 1 in 6 people
• Declining births, medical advances
• Europe, Japan, China
• More serious challenges than U.S.
• Personal (privatized) saving accounts
• Developing countries
• Government or privatized programs

LO1

Source: The World Factbook, http://www.cia.gov. Data are 2009 estimates.

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Total Fertility Rates, 2009

15-20

Population expected to peak at about 9 billion around mid-century then start declining

Options for Fixing Social Security

• Raising payroll taxes
• Raise the tax rate
• Eliminate the maximum taxable earnings
• Make it progressive rather than regressive
• Tax all income
• Similar to Personal Income Tax
• Raising the early and normal retirement ages (70?)

Options for Fixing Social Security

• Reduce benefits
• Across the board
• Use a “means test”: Those with high incomes or substantial wealth would get less of their calculated benefits than those with lower incomes
• Social Security would no longer be an entitlement
• Eliminate benefits to wealthy individuals

Options for Fixing Social Security

• Eliminate or reduce the adjustment for inflation (same as gradually reducing benefits)
• Investing the trust fund in corporate stocks and bonds rather than government securities
• Carving out some of the payroll tax for privatized individual accounts (privatization)
• Criticism: How many people know how to manage money?
• Redirecting legal immigrants to higher-skilled, higher paying work

Conservative versus Liberal

Liberals

• Support social insurance
• Worry about the regressivity of the Social Security payroll
• Want to make changes to ensure the continued financial viability of the system
• Don’t worry about
• Size of the system
• System represents big government

Conservatives

• Social Security = big government
• Better off if we did not have to pay Social Security taxes
• Tax break, to provide for ourselves in retirement or disability through private investments
• Partial or total privatization
• Favor making Social Security voluntary