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Economics: Theory Through Applications

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Chapter 28Social Security

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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?

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?

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Social Security: The Individual’s View

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lifetime income income during working years income during retirement years

lifetime consumption lifetime income

lifetime consumption $1,800,000annual consumption $30,000.

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Figure 28.1 - Lifetime Income

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Figure 28.2 - Lifetime Consumption

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Figure 28.3 - Lifetime Consumption and Saving

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Figure 28.4 - Lifetime Wealth Accumulation

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Figure 28.5 - Lifetime Consumption and Saving

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Household Budget Constraints

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disposable income consumption household saving

total lifetime consumption total lifetime income

discounted present value of lifetime consumption discounted present value of lifetime income

total

lifetime consumption total lifetime income working years disposable income

retirement years social security payment

The Life-Cycle Model of Consumption

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consumption autonomous consumption marginal propensity to consume

disposable income

working years disposable income retirement years social security payment

lifetime incomeconsumption

working years + retirement years

The Government Budget Constraint

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government surplus government revenues government transfers government expenditures

government deficit government surplus government transfers government expenditures

government revenues

Applying the Tools to Social Security

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disposable income income social security tax

lifetime resources income from working social security income working years income

working years social security tax retirement years soc

ial security income

government revenues number of workers social security tax

government transfers number of retirees social security payment

number of workers social security tax number of r

etirees social security payment

Applying the Tools to Social Security

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number of workers working years

number of retirees retirement years

working years social security tax retirement years social security payment

lifetime resources income from working social

security income

Figure 28.6 - Baby Boom in the United States and the United Kingdom

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Figure 28.7 - The US Baby Boom over Time

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A Baby Boom in Our Model

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number of workers social security tax number of retirees social security payment

annual social security payment to each worker

number of workers social security tax

number of retirees

Social Security Imbalances

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tax revenues number of workers social security taxes number of workers tax rate income

social security payments number of retirees social security payment

social security surplus number of

workers tax rate income

number of retirees social security payment

trust fund balance this year trust fund balance last year social security surplus this year

Resolving the Problem: Some Proposals

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social security surplus number of workers tax rate income

number of retirees social security payment

Positive Real Interest Rates

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next year's income discounted present value

1 real interest rate

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

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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

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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

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

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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

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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

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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

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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

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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

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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

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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

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