ECN340

Public Finance
Topic 1: SOCIAL SECURITY
Chapter 11

Dr. Shahriar Kabir/ IUB 1

Social Security Expenditures
(1939-2011)

Source: Social Security Trustees [2012].

Dr. Shahriar Kabir/ IUB

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
 Adverse selection

Dr. Shahriar Kabir/ IUB

11-3
Other Justifications

 Lack of foresight and paternalism

 Moral hazard
 Economize on decision-making and
administrative costs
 Income Redistribution
 Improve the Economic Status of the
Aged
Dr. Shahriar Kabir/ IUB

11-4
 Fully Funded Plan

Period 1 Period 2 Period 3 Period 4

The Greatest Work Retire Dead Still

Generation contribut benefits Dead
e Each generation’s
benefits based on
The Baby Boom Childhood Work Retire
deposits it made Dead
Generation during working
contribut life
benefits
e plus accumulated
Unborn Childhood interest
Work Retire
Generation X
contribut benefits
e
Dr. Shahriar Kabir/ IUB

11-5
 Pay As You Go (or Unfunded) System

Period 1 Period 2 Period 3 Period 4

Each
benefits generation’s
benefits come
The Greatest Work Retire from tax Still
Dead
payments
Generation contribut benefits made by Dead
e
current
The Baby Boom Childhood Work Retire
workers Dead
Generation contribut
benefits
e

Generation X Unborn Childhood Work Retire

contribut benefits
Dr. Shahriar Kabir/ IUB e
11-6
 Today’s Partially Funded System

Period 1 Period 2 Period 3 Period 4

benefits Baby Boomers and
Gen X are also
The Greatest Work Retire contributing
Deadto Still
Generation contribut their own Dead
benefits
e retirement
The Baby Boom Childhood Work Retire Dead
Generation contribut
benefits
e

Generation X Unborn Childhood Work Retire

contribut benefits
Dr. Shahriar Kabir/ IUB e
11-7
Explicit Transfers

 Benefits for dependents and

survivors (1939)
 Supplemental Security Income

Dr. Shahriar Kabir/ IUB

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

Dr. Shahriar Kabir/ IUB

11-9
Benefit Structure
If AIME < $711➔ PIA = .90*AIME
If $711< AIME <$4288 ➔ PIA = .90*$711 + .32*(AIME - $711)
If AIME > $4288 ➔ PIA = .90*$711 + .32*($4288-$711) + .15*(AIME -
$4288)
$2,500
First
$2,000 Break
Point
$1,500
Second
$1,000 Break
Point
$500

$0
$0 $1000 $1500 $2000 $2500 $3000 $3500 $4000 $5000 $5500
Dr. Shahriar Kabir/ IUB

11-10
Adjustments

 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

Dr. Shahriar Kabir/ IUB

11-11
Adjustments

 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)

Dr. Shahriar Kabir/ IUB

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?

Dr. Shahriar Kabir/ IUB

11-13
Distributional Issues

 Actuariallyfair 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
Dr. Shahriar Kabir/ IUB

11-14
 Single Male Single Fem ale

400 400

Social
200 200

Thousands of 2006 Dollars

0 0 Low
Low
-200 -200 Average

Security
Average

-400 High -400 High

Max
-600 Max
-600
-800
-800

Wealth:
-1000
-1000

40

60

80

00

20

40

60
19

19

19

20

20

20

20
Year Cohort Turns 65 Year Cohort Turns 65

Representative One-earner Couple Tw o-earner Couple

Individuals 400 400

200
200

Thousands of 2006 Dollars

Thousands of 2006 Dollars

0
Source: Updated tables, 0
Low Low
furnished by C. Eugene -200
Average Average
Steuerle and Adam -200
Carasso, 2006. -400
High High
Max Max
See C. Eugene Stueuerle -400
and Jon M. Bakija [1994] -600
for original tables and
-600
methodology. -800

All values expressed in -1000 -800

2006 dollars.

40

60

80

00

20

40

60
40

60

80

00

20

40

60

19

19

19

20

20

20

20
19

19

19

20

20

20

20

Dr. Shahriar Kabir/ IUB Year Cohort Turns 65 Year Cohort Turns 65

11-15
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

Dr. Shahriar Kabir/ IUB

11-16
The Social Security Trust Fund

Worker Trust
Retiree
Fund

 Social Security and National Saving

 Budget Treatment of Social Security
 Off budget
 Unified budget
Dr. Shahriar Kabir/ IUB

11-17
Social Security and Savings
Behavior

 Life-cycletheory of savings
 Wealth Substitution Effect
 Retirement Effect
 Bequest Effect

Dr. Shahriar Kabir/ IUB

11-18
 Budget Constraint for Present
and Future Consumption
Future consumption (c1)

At endowment
point (A)
D
I1 + (1+r) S (1+r)S consumer neither
saves nor
A B borrows

I1
(1+r)B
S F
I1 - (1+r) B

M
I0 - S I0
Dr. Shahriar Kabir/ IUB
Present consumption (c0)
11-19
Utility-maximizing Choice of
Present and Future Consumption
Future consumption (c1)

E1
c1*

A
I1

Saving

M
Present consumption (c0)
Dr. Shahriar Kabir/ IUB
c0* I0
11-20
Crowding out of private saving
due to Social Security
Future consumption (c1)

E1
c1*
R

A
I1
(1+r)T
T
Saving after
Saving before
Social Security
Social Security

M
Dr. Shahriar Kabir/ IUB
c0* I0T I0 Present consumption (c0)
11-21
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

Dr. Shahriar Kabir/ IUB

11-22
Retirement Decisions

 Social Security wealth and the

retirement decision
 Empirical evidence
 Diamond and Gruber [1999]
 Gruber and Wise [2004]

Dr. Shahriar Kabir/ IUB

11-23
 Long-Term Stresses on Social Security
Projected revenues and projected costs of Social Security as share of Gross Domestic Product

Source: Social Security Trustees [2012]

11-24
Long-Term Stresses on Social
Security
Since: B = t * (Nw/Nb) * w
Rearrange: t = (Nw/Nb) * (B/w)
Dependency Ratio
Replacement Ratio

Dr. Shahriar Kabir/ IUB

11-25
Social Security Reform

 Time horizon for solvency

 Sustainable solvency

Dr. Shahriar Kabir/ IUB

11-26
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

Dr. Shahriar Kabir/ IUB

11-27
Privatize the System

 Personal Accounts
 Pros and cons of personal accounts
 Effect on Solvency
 Effect on Saving
 Carve-out accounts
 Add-on accounts
 Risk
 Administration
 Distribution

Dr. Shahriar Kabir/ IUB

11-28