CHAPTER 11

SOCIAL
SECURITY

Copyright 2008 by The McGraw-Hill Companies, Inc. All rights reserved.

Sources: Expenditure data from Social Security Trustees [2006]. CPI data from Department of Labor's Bureau of Labor Statistics.
GDP data from Department of Commerce's Bureau of Economic Analysis.

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
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

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

Dead

Each generations
benefits
benefits based on
deposits it made during
Retire
Work
working life plus
accumulated interest
contribute
benefits

Childhood

Work
contribute

Still
Dead
Dead
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 generations
Dead
Still
benefits come from tax
Dead
payments made by
current workers

Retire

Dead

contribute

benefits

Childhood

Work

Retire

contribute

benefits
11-6

Todays 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
Dead to
their own
benefits
retirement

Work

Retire

Still
Dead
Dead

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 < $656 PIA = .90*AIME
If $656< AIME <$3955 PIA = .90*$656 + .32*(AIME - $656)
If AIME > $3955 PIA = .90*$656 + .32*($3955-$656) + .15*(AIME $3955)

First Bend Point

Second Bend Point

11-10

Adjustments

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 15/24th of one

percent a month
11-11

Adjustments

Family Status

+50% for spouse or dependent child

If covered worker dies spouse receives 100% of workers benefit or
spouses benefit
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 $12,480

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)

2006 Social Security Tax rates

Employee
6.2% (OASI - 5.6%, DI - .6%) of first $94,200 of earnings on both
employee and employer
Self-employed

2006 Medicare Tax rates

12.4%

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

Social Security
Wealth for
Representative
Individuals

Source: Updated tables,

furnished by C. Eugene
Steuerle and Adam Carasso,
2006.
See C. Eugene Stueuerle and
Jon M. Bakija [1994] for
original tables and
methodology.
All values expressed in 2006
dollars.

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

11-16

The Social Security Trust Fund

Worker

Trust
Fund

Retiree

Social Security and National Saving

Budget Treatment of Social Security

Off budget

Unified budget
11-17

Social Security and Savings Behavior

Life-cycle theory of savings

Wealth Substitution Effect

Retirement Effect

Bequest Effect

11-18

Empirical Evidence

Martin Feldsteins work

CONS = f(DI, W, SSW, X)

MPCssw = .028

60% reduction in personal saving

Others

Rosen: Social security has had a negative effect on

saving, but magnitude of effect is unclear

11-19

Effects on Retirement and Labor Supply

1930 LFPR 65+ was 54%

2001 LFPR 65+ was 18%

Effect of Social Security

Income Effect SS raises retirement income

Substitution Effect SS reduces the cost of retiring

Earnings test

Impact on Younger Workers?

11-20

Distribution of Wealth

Bequeathable v Annuitized Wealth

Effect of Social Security on Bequeathable

Wealth

Effect on Wealth Mobility

11-21

Future consumption (c1)

Budget Constraint for Present and Future Consumption

N
D

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

I1 + (1+r) S

I1
F

I1 - (1+r) B

(1+r)B

M
I0 - S

I0

Present consumption (c0)

11-22

Future consumption (c1)

Utility-maximizing Choice of Present and Future

Consumption
N

c1*

E1

I1

Saving
M
c0*

I0

Present consumption (c0)

11-23

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
SocialSocial Security
Security
M
c0*

I0T

I0

Present consumption (c0)

11-24

Other ways Social Security Affects Saving

Retirement effect

Bequest effect

Empirical evidence

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

Add-on accounts

Risk

Administration

Distribution
11-31

Policy Perspective: President Bushs Social

Security Reform Proposal

Voluntary personal accounts

Carve-outs

Government management

Portfolio limitations

Benefit offsets

Inheritability

Achieving sustainable solvency

Progressive indexing
11-32

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

11-33

Ida Mae Fuller

11-34