1. SOCIAL SECURITY
Chapter 11

2. Social Security Expenditures (1939-2011)
Source: Social Security Trustees [2012].

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

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

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

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

7. Today’s Partially Funded System
Period 1
Period 2
Period 3
Period 4
contribute
benefits
Baby Boomers and Gen X are also contributing to their own retirement
The Greatest
Generation
Work
Retire
Dead
Still Dead
contribute
benefits
The Baby Boom
Generation
Work
Retire
Childhood
Dead
contribute
benefits
Unborn
Childhood
Work
Retire
Generation X
benefits

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

9. Benefits How to calculate 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

10. Benefit Structure If AIME < $711 PIA = .90*AIME

11. 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)

12. Financing FICA (Federal Insurance Contribution Act)
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?

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

14. Ida Mae Fuller
Photo of Ida Mae Fuller is from the Social Security web site
Ida Mae Fuller – first recipient of monthly Social Security Benefits; retired Nov. 4, 1939 and lived to 99. Collected $20,897 on a tax of $24.85

15. Social Security Wealth: 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.

16. 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

17. The Social Security Trust Fund
Worker
Retiree
Trust
Fund
Social Security and National Saving
Budget Treatment of Social Security
Off budget
Unified budget

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

19. Budget Constraint for Present and Future Consumption
At endowment point (A) consumer neither saves nor borrows
Future consumption (c1) D
I1 + (1+r) S
(1+r)S B A I1
(1+r)B S F
I1 - (1+r) B M
I0 - S I0
Present consumption (c0)

20. Utility-maximizing Choice of Present and Future Consumption
Future consumption (c1) E1
c1* A I1
Saving M
c0* I0
Present consumption (c0)

21. Crowding out of private saving due to Social Security
Future consumption (c1) E1
c1* R A I1
(1+r)T
Saving after Social Security T
Saving before Social Security M
c0*
I0T I0
Present consumption (c0)

22. 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

23. Other ways Social Security Affects Saving
Retirement effect
Bequest effect
Empirical evidence

24. Distribution of Wealth
Bequeathable vs. Annuitized Wealth
Effect of Social Security on Bequeathable Wealth
Effect on Wealth Mobility
Payroll tax reduces everyone’s incentive to acquire bequeathable wealth, but it has a disproportionate effect on low-earners
Conclusions based on simulated results so they are not especially strong conclusions

25. Retirement Decisions
Social Security wealth and the retirement decision
Empirical evidence
Diamond and Gruber [1999]
Gruber and Wise [2004]

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 [2012]
11-26

27. Long-Term Stresses on Social Security
Since: B = t * (Nw/Nb) * w
Rearrange: t = (Nw/Nb) * (B/w)
Dependency Ratio
Replacement Ratio

28. Social Security Reform
Time horizon for solvency
Sustainable solvency

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

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