1. 28-1 Economics: Theory Through Applications

2. 28-2 This work is licensed under the Creative Commons Attribution-Noncommercial-Share Alike 3.0 Unported License. To view a copy of this license, visit http://creativecommons.org/licenses/by-nc-sa/3.0/or send a letter to Creative Commons, 171 Second Street, Suite 300, San Francisco, California, 94105, USA

3. 28-3 Chapter 28 Social Security

4. 28-4 Learning Objectives How do households respond to variations in income over their lifetime? What is the government’s budget constraint in a pay-as-you-go social security system? What is the effect of Social Security on lifetime income? What is the lifecycle model of consumption? What are the effects of changes in a pay-as-you-go social security system? What is the current state of the social security system in the U.S.? What are some of the policy choices being considered?

5. Learning Objectives What are the benefits of having a social security system? How does a social security system help someone deal with the uncertainties of life? What are the effects of social security of national saving? What aspects of the real world are highlighted and which are missed in our simple framework? Why do people disagree about social security reform? 28-5

6. Social Security: The Individual’s View 28-6

7. Figure 28.1 - Lifetime Income 28-7

8. Figure 28.2 - Lifetime Consumption 28-8

9. Figure 28.3 - Lifetime Consumption and Saving 28-9

10. Figure 28.4 - Lifetime Wealth Accumulation 28-10

11. Figure 28.5 - Lifetime Consumption and Saving 28-11

12. Household Budget Constraints 28-12

13. The Life-Cycle Model of Consumption 28-13

14. The Government Budget Constraint 28-14

15. Applying the Tools to Social Security 28-15

16. Applying the Tools to Social Security 28-16

17. Figure 28.6 - Baby Boom in the United States and the United Kingdom 28-17

18. Figure 28.7 - The US Baby Boom over Time 28-18

19. A Baby Boom in Our Model 28-19

20. Social Security Imbalances 28-20

21. Resolving the Problem: Some Proposals 28-21

22. Positive Real Interest Rates 28-22

23. Key Terms Lifetime budget constraint: According to the lifetime budget constaint, the discounted present value of lifetime income equals the discounted present value of lifetime consumption Lifecycle model of consumption: The lifecycle model of consumption studies how an individual chooses a lifetime pattern of saving and consumption given a lifetime budget constraint Real interest rate: The rate of return specified in terms of goods not money 28-23

24. Key Terms Consumption function: The consumption function is a relationship between current disposable income and current consumption Marginal propensity to consume: The marginal propensity to consume is the amount consumption increases when disposable income increases by a dollar Life-cycle model: The lifecycle model of consumption studies how an individual chooses a lifetime pattern of saving and consumption given a lifetime budget constraint 28-24

25. Key Terms Government revenues: Money that flows into the government sector from households and firms, largely through taxation, is called government revenues Government purchases (government expenditures): Government purchases equals spending by the government on goods and services Transfers: Transfers, such as unemployment insurance and medicare, are payments from the government to the household sector of the economy Government deficit: The difference between government outlays and revenues 28-25

26. Key Terms Dependency ratio: The dependency ratio is the ratio of retirees to workers Fully-funded social security system: In a fully funded social security system, the government taxes income and invests it on behalf of the household, paying back the saving with interest during retirement years Annuity: An annuity is an assets that pay out a certain amount each year while you are alive, and so insures against the uncertain time of your death 28-26

27. Key Terms Government surplus: The government surplus is equal to total tax revenues collected by the governments less its purchases of goods and services and transfers to households Moral hazard: Moral Hazard is an incentive problem that arises when the provision of insurance leads individuals to make riskier choices 28-27

28. Key Takeaways Household’s respond to variations in income over their lifetime through adjustments in saving to smooth consumption In a pay-as-you-go social security system, the government’s payments to social security recipients exactly matches the revenues received from workers The integration of the government and household budget constraints implies that in a pay-as-you-go system, social security influences household saving but leaves lifetime income unchanged 28-28

29. Key Takeaways The lifecycle model of consumption states that the household chooses the level of consumption in period of life subject to a budget constraint that the discounted present value lifetime income must equal the discounted present value of lifetime consumption If the household chooses to perfectly smooth consumption, then consumption in each period of life is equal to the discounted present value of income divided by the number of years in a lifetime 28-29

30. Key Takeaways In general, a household’s lifetime income and consumption are independent of the taxes and benefits of a pay-as-you-go social security system – Changes to the social security system lead to adjustments in saving rather than consumption Many studies predict that the social security system will be bankrupt by the middle of this century if there are no policy changes – A main causes of this problem is demographic change: fewer workers are supporting more retirees, and life expectancies have increased 28-30

31. Key Takeaways Some possible policy remedies include raising taxes on workers, reducing benefits, increasing the retirement age and privatizing the social security system Some benefits of a social security system arise from the provision of insurance over the uncertainties of life and in helping people make one in a lifetime choices that are very complex Through the social security system, retirees receive benefits until they die – This is a form of insurance to deal with the uncertainties of life Since a pay-as-you-go social security system provides income during retirement years, it reduces the incentive for households to save 28-31

32. Key Takeaways The framework we presented captures well the idea that saving is used to smooth consumption over a lifetime and that lifetime income includes both the taxes paid during working years as well as retirement benefits received – The framework did not allow for positive real interest rates or for economic growth – It also ignored uncertainties of life Much of the disagreement about social security can be traced to a debate about the value of social security in terms of providing insurance over uncertain lifetimes and the ability of individuals to act in their own interest when making consumption and saving choices 28-32

33. Key Takeaways Much of the disagreement about social security can be traced to a debate about the value of social security in terms of providing insurance over uncertain lifetimes and the ability of individuals to act in their own interest when making consumption and saving choices – Also, some opponents of social security view it as intrusive since households do not have a choice of being in the system 28-33