Social Security Today: From the origins of Social Security to today’s structure; Long-run problems due to the graying of America

Today: Social Security Some people rely on SS for a majority of their income How many of you pay less than $500 for rent on an apartment? Let’s see what $500 can rent in Memphis

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Price checked May 2010 Studios from $445

Today We analyze another benefit that most seniors receive  Social Security (SS) Questions  How did Social Security begin?  What is today’s structure?  How is the graying of America affecting SS?  How do we solve the long-run challenges to SS?  How do people change their behavior with the implementation of SS?

How did Social Security begin? SS, which is officially Old Age, Survivors, and Disability Insurance, began in 1937  White male work categories initially were covered  Coverage grew to more people over the next 50 years or so Justification for SS  What if I outlive my money? Indirectly transfers money from those that die young to those that die old  Directly, the transfer is from workers to retirees

Fully funded? Original idea involved having a large fund to pay benefits out of Political pressure turned SS into a pay-as- you-go system  The current generation of workers pays for today’s retirees  There has been some money in reserve Reserves projected to diminish starting in 2017

Fully Funded Plan Period 1Period 2Period 3Period 4 contribute benefits contribute benefits contribute benefits The Greatest Generation The Baby Boom Generation Generation X WorkRetireDead Unborn Work Retire Still Dead DeadChildhood Retire Each generation’s benefits based on deposits it made during working life plus accumulated interest

Period 1Period 2Period 3Period 4 The Greatest Generation The Baby Boom Generation Generation X WorkRetireDead Unborn Work Retire Still Dead Dead Childhood Retire contribute benefits contribute benefits contribute benefits Pay As You Go (or Unfunded) System Each generation’s benefits come from tax payments made by current workers

Projected revenues and payments of SS In 2017, payments are projected to exceed tax revenue

Growth of SS in the US

How does SS work? Mostly pay-as-you-go, or unfunded, financing  Recall that some reserves exist Financing  Current workers pay, retirees receive Retirement age  “Normal” age is gradually increasing Benefit structure  Based on average indexed monthly earnings

Financing In 2006, each of the first $94,200 was subject to SS taxes  12.4%, evenly split between employee and employer  Note that Medicare financing is separate from SS Taxes create illusion of obligation to future generations  SS could be eliminated if the federal gov’t decided to do so SS tax rates over time

The Social Security Trust Fund Money flow shown above  Workers pay into the trust fund  Retirees receive money from the trust fund Worker Retiree Trust Fund

Retirement age Year of birthFull retirement ageMonths between age 62 and full retirement age 1937 or earlier and 2 months and 4 months and 6 months and 8 months and 10 months and 2 months and 4 months and 6 months and 8 months and 10 months or later is minimum retirement age (with reduction in benefits)

Benefit structure Based off average indexed monthly earnings (AIME)  Top 35 years of wages, factored for inflation 2006 benefit formula: Primary insurance amount (PIA)  90% of first $656 of AIME, plus  32% of AIME between $656 and $3,955  15% above $3,955  Cap on benefits based on maximum taxable earnings subject to SS payroll tax

Benefit structure AIME PIA First Bend Point Second Bend Point

Long-run problems with SS Population growth in some countries is stagnating Populations are getting older on average Both problems are putting pressure to do at least one of the following  Decrease benefits  Increase the retirement age  Increase SS taxes

A simple model Assume three equal periods of life  Childhood  Working years  Retirement Suppose that each generation is twice as big as the previous one  Twice as many workers as retirees  Workers pay less into SS than they receive when they retire

Stagnation in population growth Population growth has stagnated in some developed countries  Example: Greece, 2007 estimates Current population growth is 0.16% per year Childbearing is not keeping up with death rates  1.35 children born per woman’s childbearing years  Only positive net migration is keeping Greece’s population from falling (Source:

Greek population Source: Demographics_of_Greece Year Thousands of people

Graying of the population America is currently “graying” in two ways  Americans are living longer Life expectancy  : 69.9 years  2004: 77.8 years Infant mortality  : 2.6%  2004: 0.68%  Baby boom generation has begun to retire Statistics from Center for Disease Control and Prevention website

Graying of the population This graph show the number of people aged 0-99 in 1999 Baby boom generation (roughly)

Some possible solutions to SS problem In order to have sustainable solvency of the SS system in the US, additional financing equivalent to a 3.5 percentage point increase in the payroll tax must be achieved Some other possible solutions  Raise the maximum taxable earnings level  Raise the retirement age  Reduce the cost-of-living adjustment  Change the benefit formula  A combination of options

Warning Secondary effects must be taken into account with SS reform  Be careful about increasing taxes In Chapter 15, we will see that tax increases can cause other problems in the economy  Increasing the retirement age could increase the supply of workers Could lead to lower wages for all workers

What will happen to SS? Over the next decade, one of several things could occur to SS  Nothing: Let the next generation solve the problem Waiting too long could lead to social unrest Politically, your age group is the “next generation”  Partly solve the problem Current solvency: years Some proposals would increase this to 75 years  Fully solve the problem (not likely)

How do people change behavior with SS? With SS, people change their behavior in the working years We will examine the life-cycle theory of savings  Wealth substitution effect  Retirement effect  Bequest effect

Life cycle theory of savings People save and borrow based on planned lifetime consumption Somebody with diminishing MU prefers smooth consumption over time  Without SS, a rational person will save during the working years and use this money for retirement

Budget constraint for present and future consumption Present consumption (c 0 ) Future consumption (c 1 ) N M I0I0 I1I1 D I 0 - S I 1 + (1+r) S S (1+r)S I 1 - (1+r) B F B (1+r)B At endowment point consumer neither saves nor borrows

Wealth substitution effect Along the budget constraint, suppose I am forced to have $1 less today and $(1 + r) more in future consumption This will lead to $1 less in saving today  Crowds out private saving  Known as the wealth substitution effect

Utility-maximizing choice of present and future consumption Present consumption (c 0 ) Future consumption (c 1 ) N M I0I0 I1I1 E1E1 c1*c1* A c0*c0* Saving

Crowding out of private saving due to SS Present consumption (c 0 ) Future consumption (c 1 ) N M I0I0 I1I1 E1E1 c1*c1* A c0*c0* R T I0TI0T (1+r)T Saving before Social Security Saving after Social Security

Retirement effect SS gives workers a financial incentive to retire early  Retirement effect states that people may save more in their working years in order to have their desired consumption during a longer retirement period

Bequest effect Some people may feel guilty with the fact that their children are financing their retirement  Bequest effect states that people save more during their working years to finance a larger bequest to their children when they die

Summary SS is a big part of the US economy  About 4.25% of GDP  Private saving likely changes when SS is introduced An idea of fully-funded SS system turned into a pay-as-you-go system Reforms will need to be made in order to make SS solvent for your retirement

Next lecture: Parts of Chapters 12 and 13 Distribution of income (I will present this differently than the textbook) Rationales for redistribution In-kind versus cash transfers Various welfare programs for the poor  TANF  EITC  Supplemental Security Income  Medicaid  Unemployment insurance

Problems Contributions to Social Security Crowding out of private saving

Problem 1 Contributing to Social Security  Assume 2006 structure Earnings taxed up to $94, % tax rate, split evenly between employee and employer  How much is paid by employee if earnings are… $40,000? $80,000? $120,000? $160,000?

Problem 1 Explicitly, the employee only pays half of the tax  6.2% 6.2% of $40,000 is $2, % of $80,000 is $4,960 For the last two incomes listed on the previous page, the employee “maxes out”  6.2% of $94,200 is $5,840.40

Problem 2 Crowding out private saving  Assume two periods Working years (period 1) Retirement years (period 2) Real interest rate of 20% between two periods  Earnings of $1,000,000 in period 1, $0 in period 2  Utility is product of consumption in each period

Problem 2 What will consumption be in each period without social security? What happens if the government provides the following social security system?  $200,000 in SS taxes in period 1  $240,000 in SS payments in period 2

Problem 2: Case 1 No social security  Utility is c 1 c 2  Constraint ( ) c 1 + c 2 = $1,200,000  Equivalent to $1,000,000 consumed in period 1, $1,200,000 consumed in period 2, or a linear combination Same as c 2 = $1,200,000 – 1.2c 1  Solution max c 1 c 2 s.t. c 2 = $1,200,000 – 1.2c 1 Equivalent to max c 1 (1,200,000 – 1.2c 1 )

Problem 2: Case 1 Solve max 1,200,000c 1 – 1.2c 1 2 Set FOC equal to zero 1,200,000 – 2.4c 1 = 0 c 1 = 500,000 The rest of consumption goes to period 2  Save $500,000 of earnings in period 1  Add 20% interest (100,000) $600,000 consumption in period 2

Problem 2: Case 2 What happens with SS system  $200,000 of saving gets diverted to SS system  Implicit 20% return when retired Same outcome as in Case 1, except $300,000 is saved instead of $500,000

Seniors in protest? Dear Senator, I have voted for you for the last 30 years. Now that I’m retired, you’d better not lower my cost-of- living adjustment. Have a nice day, Mr. Not Working What’s next? Attacking politicians with walkers and canes?