CHAPTER 11 Social Security Copyright © 2010 by the McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin

11-2 Social Security Expenditures ( ) Source: Social Security Trustees [2008].

11-3 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

11-4 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

11-5 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

11-6 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

11-7 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 Today’s Partially Funded System Baby Boomers and Gen X are also contributing to their own retirement

11-8 Explicit Transfers Benefits for dependents and survivors (1939) Supplemental Security Income

11-9 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

11-10 Benefit Structure If AIME < $711  PIA =.90*AIME If $711< AIME <$4288  PIA =.90*$ *(AIME - $711) If AIME > $4288  PIA =.90*$ *($4288-$711) +.15*(AIME - $4288)

11-11 Adjustments Annual inflation adjustment Age at which benefit is drawn –Normal retirement age –Early retirement – benefit reduced 5/9 th of one percent a month for first 36 months preceding normal retirement age –Late retirement – benefit increased 8% a year

11-12 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 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.)

11-13 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?

11-14 Distributional Issues Actuarially fair return Intergenerational redistribution –Total benefits = N b * B –Total taxes = t * N w * w –If total benefits = total taxes: N b * B = t * N w * w or B = t * (N w /N b ) * w Ida Mae Fuller

11-15 Ida Mae Fuller

11-16 Social Security Wealth: Representative Individuals Source: Updated tables, furnished by C. Eugene Steuerle and Adam Carasso, See C. Eugene Stueuerle and Jon M. Bakija [1994] for original tables and methodology. All values expressed in 2006 dollars.

11-17 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

11-18 The Social Security Trust Fund Social Security and National Saving Budget Treatment of Social Security –Off budget –Unified budget Worker Retiree Trust Fund

11-19 Social Security and Savings Behavior Life-cycle theory of savings Wealth Substitution Effect Retirement Effect Bequest Effect

11-20 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

11-21 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

11-22 Crowding out of private saving due to Social Security 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

11-23 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

11-24 Other ways Social Security Affects Saving Retirement effect Bequest effect Empirical evidence

11-25 Distribution of Wealth Bequeathable vs. Annuitized Wealth Effect of Social Security on Bequeathable Wealth Effect on Wealth Mobility

11-26 Retirement Decisions Social Security wealth and the retirement decision Empirical evidence –Diamond and Gruber [199] –Gruber and Wise [2004]

11-27 Long-Term Stresses on Social Security Source: Social Security Trustees [2006] Projected revenues and projected costs of Social Security as share of Gross Domestic Product

11-28 Long-Term Stresses on Social Security Since: B = t * (Nw/Nb) * w Rearrange: t = (Nw/Nb) * (B/w) Dependency RatioReplacement Ratio

11-29 Social Security Reform Time horizon for solvency –Sustainable solvency

11-30 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

11-31 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