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1 of 41Public Finance and Public Policy Jonathan Gruber Fourth Edition Copyright © 2012 Worth PublishersCopyright © 2010 Worth Publishers

2 of 41Public Finance and Public Policy Jonathan Gruber Fourth Edition Copyright © 2012 Worth Publishers

13

Dan Sacks

P R E P A R E D B Y

13.1 What Is Social Security and How Does It Work?

13.2 Consumption-Smoothing Benefits of Social Security

13.3 Social Security and Retirement

13.4 Social Security Reform

13.5 Conclusion

Social Security

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C H A P T E R 1 3 ■ S O C I A L S E C U R I T Y

Public Finance and Public Policy Jonathan Gruber Fourth Edition Copyright © 2012 Worth Publishers

13.1

• Social Security: A federal program that taxes workers to provide income support to the elderly.

• How Is Social Security Financed?

o Through the Federal Insurance Contributions Act (FICA) tax on their earnings.

• Who Is Eligible to Receive Social Security?

o A person must have worked and paid this payroll tax for 40 quarters (10 years) over their lifetime, and must be age 62 or older.

What Is Social Security and How Does It Work?

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13.1

• Beneficiaries receive annuity payments.o Annuity payment: A payment that lasts until the

recipient’s death.

• Payment size depends on the recipient’s average earnings over the 35 highest earning years, called the Average Indexed Monthly Earnings, or AIME.

• Benefits are a redistributive function of past earnings, as the replacement rate falls with AIME.

o Replacement rate: The ratio of benefits received to earnings prior to the entitling event.

How Are Social Security Benefits Calculated?

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13.1

Social Security Benefits as a Function of Earnings

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13.1

• Using the 35 highest years reflects multiple concerns.o No penalty for low-earning years early in career.o Not too large a benefit for high earning years late

in career.

• Too short a window leads to abuse:o Bus driver working 25-hour shifts to maximize

pension payment.o Brazilian public employees receiving promotions

right before retirement.

APPLICATION: Why Choose 35 Years?

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• Can claim at early entitlement age, but it reduces benefits by 6.67% for each year before full benefit age.

o Full Benefits Age (FBA): The age at which a Social Security recipient receives full retirement benefits (Primary Insurance Amount).

o Early Entitlement Age (EEA): The earliest age at which a Social Security recipient can receive reduced benefits.

• Delaying beyond FBA increases benefits by 8%/year, called the Delayed Retirement Credit (DRC).

13.1

How Does Claiming Benefits Work?

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13.1

• Can you work and receive Social Security?

o The earnings test reduces the benefits of 62- to 64-year-olds by $0.50 for each dollar of earnings they have above $13,560.

o These benefits are returned later when the worker’s earnings fall below this threshold.

• Can family members receive benefits?o Spouses of claimants, children of deceased

workers, and spouses who survive a Social Security recipient all receive benefits.

How Does Social Security Work?

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13.1

Review: Social Security Terms

• AIME is Average Indexed Monthly Earnings.• PIA is the Primary Insurance Amount.• FBA is the Full Benefits Age (currently age 65, rising to

67).• EEA is the Early Entitlement Age (currently age 62).• DRC is the Delayed Retirement Credit amount (8%).

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13.1

Pension systems can be funded or unfunded.

• Funded: Today’s savings are invested in various assets in order to pay future benefits.

• Unfunded: Payments collected from today’s workers go directly to today’s retirees instead of being invested in order to pay future benefits.

• Social Security is partially funded: Today’s taxes fund some but not all of future benefits.

• This leads to redistribution from young to old.

How Does Social Security Work Over Time?

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13.1

How Social Security Redistributes Income: Social Security in a Two-Period World

Period # Young Earnings Taxes #Old Benefits Return1 100 20 0 0 02 105 21 2.1 100 2.1 Infinite3 110 22 2.2 105 2.2 10%4 115 23 2.3 110 2.3 10%5 121 24 0 115 0 −100%

• Population and earnings grow by 5% per year.• Unfunded system with 10% payroll tax.

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13.1

• The very first beneficiary of Social Security was Ida May Fuller.

• Worked for only three years after the establishment of the Social Security system, and paid a total of $24.75 in Social Security taxes: o The first Social Security check in U.S. history was

issued to her on January 31, 1940, for $22.54.o Ida May went on to live for 35 more years, dying at

age 100 in 1975. Over those 35 years, she collected a total of $22,888.92 in Social Security benefits.

Ida May Fuller

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13.1

• Unfunded Social Security systems redistribute from young to old, and the first generation are the big winners.

• Unfunded systems create legacy debt.

o Legacy debt: The debt incurred by the government because early generations of beneficiaries received much more in benefits than they paid in taxes.

Lessons Learned

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13.1

• To see how Social Security redistributes in practice, we study the Social Security Wealth of different generations.

• Social Security Wealth (SSW): The expected present discounted value of a person’s future Social Security payments minus the expected present discounted value of a person’s payroll tax payments.

How Does Social Security Redistribute in Practice?

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13.1

SSW is computed as follows:• Calculate the entire future stream of benefits that a

person expects to receive before he or she dies.• Use a discount rate to calculate the present

discounted value (PDV) of that stream of benefits.• Calculate the entire future stream of taxes that a

person expects to pay before he or she dies.• Compute the PDV of that stream of taxes.• Take the difference between these two to get the

SSW.


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13.1


SSW for a Single Male

Earnings Turns 65 in 1960

Turns 65 in 1995

Turns 65 in 2030

Low earner $26,100 $12,500 −$4,100Average earner 35,500 −5,100 −56,200

High earner 35,800 −41,100 −248,500

• Redistribution from younger to older cohorts due to:

o First cohort didn’t pay in until 1937.

o Payroll tax has increased over time.

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13.1

Some examples of how SSW varies within groups that are the same ages include the following:• Females have more SSW than males because they live

longer.• Married couples have more SSW than single people.• Single-earner couples have more SSW than two-earner

couples.• The gains to the poor relative to the rich from Social

Security are overstated because the length of life rises with income.


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13.2

• One justification for Social Security is market failure in the annuities market: o The longer a person lives, the less money the

insurer makes from an annuity contract. o This could lead to such a high price for annuities

that most people would not want to buy them.

• True reason: paternalism.o Policy makers worry that people won’t save enough.o Most workers have very little savings other than

Social Security (and private pensions).

Rationales for Social Security:

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13.2

Key question: Does Social Security smooth consumption?

• Perhaps Social Security just crowds out savings that individuals would otherwise set aside for their retirement.

• Social Security might crowd out private savings by allowing people to count on a government transfer to support their income in old age.

• The larger this crowd-out is, the less consumption smoothing Social Security provides for retired individuals.

Consumption-Smoothing Benefits of Social Security

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13.2

Living Standards of the Elderly, 1959−2009

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13.3

• Social Security benefits in the United States depend on age and earnings, both of which could be correlated with savings habits.

• In Italy, reforms in 1992 cut benefits of younger public-sector workers, relative to older public-sector workers and private-sector workers.

• Results show partial crowd-out: 30−40% of the reduction in SSW was offset by higher private savings.

EVIDENCE: Measuring the Crowd-Out Effect of Social Security on Savings

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13.3

What are the costs and benefits of working an additional year at age 62?• Costs: implicit tax.

o Pay an extra year of payroll taxes on her earnings.o Receives one year less of Social Security benefits.

• Benefits: benefit adjustment.o Higher Social Security benefit level through the

actuarial adjustment.o Increase AIME.

Social Security and Retirement: Theory

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13.3

Elderly Work and Social Security, 1959−2009

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13.3

• Retirement hazard rate: The percentage of workers retiring at a certain age.

Spike in Retirement Hazard at EEA

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13.3

Spike in Retirement Hazard at EEA

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13.3

Retirement Hazard Rate in France

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13.3

Evidence: Retirement Age in Germany, 1968−1992

• Retirement age lowed from 65 to 60 in 1973.

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13.3

APPLICATION: Implicit Social Security Taxes and Retirement Behavior

• Gruber and Wise (1999) calculated the implicit tax from Social Security for a series of countries.

• Across countries, there is a great deal of variation in the implicit tax rate.

o Implicit tax close to zero for 62-year-olds in the United States.

o 91% in the Netherlands.

• And countries with higher taxes have less elderly labor force participation.

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13.3

Implicit Social Security Taxes and Retirement Behavior

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13.3

• Evidence suggests that it is potentially very costly to design Social Security systems that penalize additional work beyond the retirement age.

• Adjusting systems to more fairly reward work at old ages can mitigate much of the moral hazard effect of Social Security.

Implications

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13.4

Social Security Reform

• Social Security faces a major fiscal imbalance as it is increasingly difficult for young generations to pay for the benefits of older generations.

o Rising life expectancy

o Falling birth rates

o Reduction in wage growth rates

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13.4

Social Security Reform

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13.4

• Commission in 1983 to improve Social Security’s finances.

• Primary recommendation:

o Social Security system should move away from an unfunded system to some extent.

o The government should accumulate savings in the Social Security trust fund so that, when the baby boomers retire, there would be enough money to pay their benefits.

Reform Round I: The Greenspan Commission

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13.4

• In theory, one benefit of the partial funding of Social Security through the build-up of the trust fund is an increase in national savings.

• The trust fund is “off budget,” not supposed to be part of budget discussion.

• But typically the government reports the deficit/surplus from the “unified budget,” which incorporates off-budget categories.

• Makes it easy to treat trust fund as an asset, avoid fixing the deficit.

APPLICATION: The Social Security Trust Fund and National Savings

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13.4

Many possible additional reforms:

• Raise taxes further

• Extend the base of taxable wages

• Raise retirement age

• Lower benefits

• Reduce benefits for high income groups

Incremental Reforms

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13.4

Fundamental reforms have also been proposed:

• Invest the trust fund in stocks

o One problem with the Greenspan Commission’s solution was that the trust fund is very inefficiently invested.

• Privatization

o A proposal to reform Social Security by allowing individuals to invest their payroll taxes in various assets through individually controlled accounts.

Fundamental Reforms

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13.4

401(k) plans are an important feature of retirement savings in the United States.

• These plans allow individuals to save in self-directed investment choices.

• But there are several problems with them:

o Some workers have as much as 80% of their assets in company stock.

o If the company fails, they will lose their job and their savings.

APPLICATION: Company Stock in 401(k) Plans

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13.4

• Middle ground between fundamental and partial reform: government regulated accounts.

o Each person would get an account…

o …but the government would limit investment choices and force annuitization.

• Over the long run, an efficient retirement portfolio should contain some stock investments.

The Trade-Offs Between Fundamental Reforms

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13.4

• A 2001 commission proposed three mixed systems for partial privatization.

• One plan let people invest up 2% of wages in a personal account.

• But all plans were expensive since they diverted payroll revenue away from current benefits, requiring other revenue to finance.

APPLICATION: Mixed Proposals for Social Security Reform

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13.4

• Leibman, McGuiness, and Samwick’s (2005) proposal:

• Cut Social Security benefits: o Reduce the values of the rate at which the PIA is

converted to the AIME and raise the Full Benefits Age to 68 and the Early Entitlement Age to 65.

• Raise new revenue:o Mandatory contributions to retirement accounts,

increase in maximum taxable earnings.• Establish individual retirement account with five

broad options.

APPLICATION: Mixed Proposals for Social Security Reform

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13.5

• Social Security is the largest social insurance program in the United States, and the largest single expenditure item of the federal government.

• Social Security faces a long-run financing problem to which there are no easy solutions.

• The question of how to resolve this problem will be one of the most contentious sources of political debate for at least the first part of the twenty-first century.

Conclusion

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