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Entitlements Social Security payment is an entitlement Payment to which eligible citizens have a right to receive by law Entitlements are huge share of federal budget, and because payments are mandated by law, they are outside discretionary control of Congress Only way payments can be decreased is to change law that entitles citizens to them 10-2

Social Security Act Social Security Act of 1935 established Social Security program Original law provided only retirement benefits at age 65 for most workers in industry and commerce Since then, law has been amended many times Social Security now has provisions for disabled workers and their dependents and for survivors of deceased workers Covers virtually entire working population, including self-employed, and benefits are tied to consumer price index so they increase automatically with inflation in economy 10-3

Social Insurance vs. Private Insurance Program provided by government and funded by payroll taxes of employers, employees, or both Social Security is good example of social insurance Purpose is pooling of risk of losses Private insurance Private program provided by for-profit insurance companies and funded by premiums 10-4

Social Insurance Social insurance is compulsory If you are a covered worker, you must pay Social Security taxes and participate in program Social Security Administration is sole provider of social insurance; is therefore a government monopoly Revenue for social insurance programs is provided by taxes earmarked for providing benefits to those who qualify Since funds are taken directly from paycheck, are referred to as payroll taxes Taxes based on earnings from work, usually deducted directly from workers’ paychecks 10-5

Social Insurance (cont.) Social Security is pay-as-you-go-system Current taxes pay current benefits Rights to benefits under Social Security is a statutory right Right specified by law If Congress changes law to make benefits either more or less generous, right to benefits will change with law Social insurance is based on principles of individual equity and social adequacy Individual equity Benefits received are proportional to amounts paid in Social adequacy Benefits are sufficient to provide minimum level of economic security to population as a whole 10-6

Private Insurance Private insurance is voluntary Private insurance industry composed of large number of competing firms, although dominated by much smaller number of large firms Funds generated from premium payments made by policyholders By law, private insurers must operate on fully funded basis Having sufficient reserves to pay all expected liabilities Rights to benefits are contractual right Right specified in contract between parties Company cannot unilaterally change terms of policy Based on principle of individual equity 10-7

Characteristics of Social Insurance and Private Insurance 10-8

Public Assistance Programs Any government program targeted to aid low-income people Public assistance programs are needs-based To receive benefits, person must demonstrate that he or she is poor or that assets and income are below certain level Benefits are paid not from earmarked taxes, but from government’s general revenues No relationship between taxes paid in, currently or in past, and benefits received by recipients Public assistance programs are pure welfare programs Because every worker is eligible for Social Security and Medicare, but only poor receive welfare, stigma is attached 10-9

Characteristics of Social Insurance and Public Assistance 10-10

Social Security Taxes Determined by tax base and tax rate Tax base Income, earnings, sales, property, or other valued items that have tax rate applied to them In case of Social Security tax, tax base is earnings subject to payroll taxes As of 2006, Social Security tax base was only first $94,200 of each worker’s annual earnings Tax rate Percentage of tax base that must be paid to government as tax As of 2006, tax rate is 6.2 percent for Social Security 10-11

Types of Taxes Regressive taxes Progressive taxes Proportional taxes Taxes that take larger percentage of income from low-income people than from high-income people Social Security tax is regressive for two reasons: Only tax base is taxed in given year Only earnings from working are taxable for Social Security and Medicare Progressive taxes Taxes that take larger percentage of income from high-income people than from low-income people Proportional taxes Taxes that take same percentage of income from people at all income levels 10-12

Social Security Benefits Mainly in form of checks mailed by U.S. Treasury to beneficiaries on first of each month To qualify for benefits, recipient must be fully insured worker or dependent of fully insured worker Benefit amounts based on retired worker’s prior Social Security tax contributions Complex formula that takes into account worker’s highest 35 years of earnings determines amount of worker’s monthly check Benefits are progressive in that low-earnings workers receive higher replacement rate than high-earnings workers do Replacement rate is percentage of final working year’s earnings that is replaced by Social Security benefits 10-13

The Long-Run Problem: An Aging Population Average age of U.S. population is increasing; implies we have fewer workers paying taxes and more retirees receiving benefits More workers are retiring at earlier ages; early retirements imply longer periods of retirement during which workers do not pay Social Security taxes but do receive benefits Baby boomers are expected to begin retiring in first decade of 21st century; that group has higher life expectancy and lower birthrate than previous generations, and will swell ranks of retired still more 10-14

Worker to Social Security Beneficiary Ratio 10-15

Social Security Act of 1983 Major provisions of amendment are: To raise normal retirement age To begin building up trust fund accounts to care for increase in benefits expected when baby boomers retire To begin to tax portion of Social Security retirement benefits for income tax purposes 10-16

Normal Retirement Age Minimum age at which workers can retire with full Social Security benefits For first 60 years of program, normal retirement age was 65 Workers can also retire at 62, but retirement benefits are proportionally reduced 1983 amendment to Social Security Act gradually raises normal retirement age By 2022, normal retirement age will be 67 Workers will still be able to retire at age 62 if willing to accept lower monthly benefits for remainder of lives Closer to normal retirement age that they are when they retire, smaller the reduction in benefits that they will incur Increase in normal retirement age means that many workers will pay taxes for two years longer, and will collect retirement benefits for two years fewer 10-17

Trust Funds Other change begun in 1983 was partial departure from pay-as-you-go philosophy of Social Security Tax levels set to increase trust fund (taxes collected and invested specifically to pay future Social Security benefits) balances to pay benefits to baby boomers Government is now collecting more taxes than needed to pay benefits to current retirees Surplus taxes invested in U.S. government securities; earn interest that is also credited to trust funds 10-18

Taxing Social Security Retirement Benefits Originally, Social Security retirement benefits were exempt from income taxation In 1984, retirees first began to pay federal income tax on Social Security benefits Taxes paid are credited to Social Security trust funds and are invested in U.S. securities About one-third of current Social Security recipients pay taxes on benefits As of 2006, individual federal tax return filers pay tax on benefits if total income is more than $25,000 For joint return filers, total income for both spouses must be more than $32,000 10-19

Long-Run Financial Viability of Social Security Board of trustees of Social Security program must file periodic reports about long-range (75-year) financial outlook In preparing reports, analysts make assumptions about: Growth in economy Growth in workforce Number of retirees Length of time that retirees collect benefits 2006 Trustees report projected that trust funds would continue to be built up over next several years and then begin to be drawn down but would not be exhausted until 2040 After funds are exhausted, will return to pay-as-you-go system Given increasing proportion of older people, change could lead to either higher Social Security taxes or decreased retirement benefits BOTTOM LINE: In short term, Social Security program is solvent, but in long run, program is not expected to be financially sound 10-20

Should Social Security Be Made Voluntary? Many conservatives argue that Social Security should be made voluntary, rather than compulsory Arguments based on principles of greater economic freedom and limitation of role of government in our lives Arguments for compulsory Social Security program are: Voluntary program would make provision of minimum level of economic security to entire population more difficult Poor could not afford to purchase private insurance or save to provide for own economic security Voluntary system would be subject to greater adverse selection Process by which insured people’s choices lead to higher-than-average loss levels for program’s sponsor 10-21

Is Social Security Unfair to Younger Workers? One of most complex issues involved in Social Security program is whether young workers will receive their money’s worth from Social Security These workers pay Social Security taxes to support currently retired persons, survivors, and disabled persons Value of taxes paid by younger workers and their employers exceed value of benefits they can expect to receive Some critics of Social Security argue that younger workers are being cheated and that they should be allowed to opt out of Social Security and purchase private insurance protection, where they will receive a fairer deal 10-22

Is Social Security Unfair to Younger Workers? (cont.) Most studies indicating that young worker is cheated under Social Security make assumption that individual employee is entitled to all of employer’s tax contribution Based on belief that firms pay lower wages to workers in order to compensate for Social Security taxes they pay on behalf of employees If this assumption is not valid, and workers do not receive lower wages because of employers’ Social Security contributions, then belief that system is unfair to younger workers is not justified Many studies supporting “bad buy” argument consider only survivor and retirement benefits Researchers assume that if individual worker were given taxes paid by both employer and employee, worker could purchase life insurance and retirement annuity more cheaply than could acquire same coverage through Social Security program Does not account for all benefits provided by Social Security (i.e., disability coverage and medical insurance through Medicare) 10-23

The Widow’s Income Gap Widows (or widowers) of covered workers can collect monthly survivorship benefits based on earnings record of deceased spouse Surviving spouse’s benefits are paid only until youngest child reaches age 16 At age 60, surviving spouse can again collect benefits on earnings record of deceased worker Benefits will be lost if surviving spouse remarries before reaching age 60 10-24

Unfair Treatment of Working Wives Wife can receive retirement benefits based on own earnings record, or can receive retirement benefits based on husband’s record Social Security Administration will pay highest retirement benefits after calculating benefits using own record and husband’s Usually, spousal benefits will be one-half of what husband receives Wives who have never worked outside the home, or who did not work enough to be fully covered for retirement benefits, are entitled to same spousal benefits as are wives who worked throughout married lives Many working wives discover they are entitled to larger spousal benefits than if they were to receive benefits based on own earnings record Appears as if tax contributions are lost, and, at least for Social Security retirement purposes, that years of working do not matter 10-25

Does Social Security Decrease Savings? Critics of Social Security program argue that it has decreased private savings in United States Need to save for retirement privately is decreased because Social Security program exists Called Social Security wealth effect Causes us to spend more during working years on consumer goods, because we do not feel the need to save Others argue that Social Security actually increases private savings by encouraging earlier retirements Called early retirement effect Workers who retire earlier must provide for longer period of retirement and therefore must save more during working years Trying to measure portion of savings affected by Social Security as opposed to portion of savings not affected by Social Security is difficult; results are inconclusive 10-26

The Future of Social Security Some changes that might be made: Altering Social Security tax Cutting current Social Security benefits Increasing retirement ages Investing Social Security taxes in stock market Partial privatization 10-27

Altering the Social Security Tax Instead of placing ceiling on amount of earnings taxed each year, put floor in place instead Very-high-income earners would be taxed more heavily than low-income earners 10-28

Cutting Current Social Security Benefits Various proposals have been made to cut current Social Security benefits Some proposals tinker with benefits formula to decrease benefits of particular earnings classes Others eliminate adjustments for inflation Eliminating such cost-of-living adjustments is form of benefits reduction Cutting current benefits would make trust funds last longer Proponents of cutting benefits argue that this would make system more progressive, keep minimum floor of income under lower and average earners, and cut costs of Social Security program Critics argue that cutting benefits might threaten individual equity principle that makes Social Security a social insurance program instead of a welfare program 10-29

Increasing Retirement Ages Another suggestion to strengthen system is to raise both normal retirement age and early retirement age Proponents of additional increase in normal retirement age point out that U.S. economy is evolving from manufacturing economy to service and information economy and, therefore, jobs are less physically demanding Also argue that advances in health care have made U.S. workers healthier in fifties and sixties Proponents of increase in early retirement age argue that workers who choose early retirement at reduced benefits often do so without realizing how long they will need to provide for themselves in retirement Raising early retirement age would encourage workers to continue working—and paying Social Security taxes—longer 10-30

Investing Social Security Taxes in the Stock Market Trust funds must be invested only in government securities, but stocks in America’s corporations often pay investors far higher rates of return than do government bonds Many critics argue that allowing managers of Social Security trust funds to invest portion of tax revenue in stock market would greatly increase investment earnings of funds Others point out that investment in stock market is more risky than investing in government securities 10-31

Partial Privatization President Bush has proposed that portions of Social Security program be privatized Original proposal was that 2 percent of worker’s earnings be put into investment accounts selected by worker Instead of Social Security Administration investing all Social Security tax revenue in government securities, worker would direct portion to be invested in stocks or mutual funds Critics argue that high-wage earners will receive more sophisticated investment advice than will low-income workers Would increase retirement income of high earners and decrease retirement income of low-income earners 10-32

The Economic Left and the Economic Right THE ECONOMIC RIGHT (Conservative) Argue that we would be better off if we did not have to pay Social Security taxes but were encouraged by some measure, such as tax break, to provide for retirement or disability through private investments Favor partial or total privatization Favor making Social Security voluntary THE ECONOMIC LEFT (Liberal) Support principle of social, not private, insurance to provide minimum floor of income support under total population Worry about regressivity of Social Security payroll tax and want to make changes to ensure continued financial viability of system 10-33