copyright © 2002 by thomson learning, inc. chapter 8 social security and social insurance copyright...

Copyright © 2002 by Thomson Learning, Inc.

Chapter 8

Social Security and Social Insurance

Copyright © 2002 Thomson Learning, Inc. Thomson Learning™ is a trademark used herein under license.

ALL RIGHTS RESERVED. Instructors of classes adopting PUBLIC FINANCE: A CONTEMPORARY APPLICATION OF THEORY TO POLICY, Seventh Edition by David N. Hyman as an assigned textbook may reproduce material from this publication for classroom

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systems—without the written permission of the publisher. Printed in the United States of America

ISBN 0-03-033652-X


Social Security Act of 1935provisions of that time:

Retirement Age: 65 Payroll Tax:

1% for employer and employee Tax applied to the first $3000 of earned

income


Other Nations and Social Insurance

Germany 1889 U.K. 1908 France 1910

Now more than 170 nations have some form of social security system.


Social Security in the United States

OASDI: Old Age Survivors Disability Insurance

HI: Health Insurance (Medicare) UI: Unemployment Insurance


FICA

Federal Insurance Contribution Act Tax rate is currently 7.65% for both

employers and employees 15.3 % for the self-employed Tax applied on earned income up to

$76,200 in 2000 (this is indexed)


Fully Funded vs Pay-As-You-Go

A Fully Funded system is where the current fund has balances sufficient to pay the present value of the future obligations.

A Pay-As-You-Go system is where current taxes pay for current benefits.

The current system is a modified pay-as-you-go system with a trust fund.


Social Security Trust Fund

Since 1982 Social Security taxes have greatly exceeded benefits.

The trust fund is an accounting mechanism by which U.S. government debt is issued to the Social Security Administration in exchange for the surpluses.

This debt will be sold to the public when taxes paid fall below what is needed to pay benefits.


How Retirement Benefits are Computed

The AIME (Average Index of Monthly Earnings) is the highest 35 years of inflation-adjusted earnings expressed in monthly terms.

The PIA (Primarily Insurance Amount) is the amount to which a individual is entitled given their AIME.


The Gross Replacement Rate is the monthly retirement benefit over the monthly labor earnings in the year prior to retirement.

The Net Replacement Rate is the monthly after-tax benefit over the monthly after-tax labor earnings in the year prior to retirement .

Replacement Rates


Worker Status Gross Replacement Rate

Low Earner 52.6%

Average Earner

39.1%

Maximum Earner

23.7%

Gross Replacement Rates by Income


Figure 8.1 How Gross Replacement Rates for Social Security Pension Recipients Vary with

Preretirement Earnings

Gro

ss

Re

pla

ce

me

nt

Ra

te (

Pe

rce

nt)

Gross Monthly Earning in the Year Prior to Retirement (Dollars)

110 100 90 80 70 60 50 40 30 20 10

0 1,000 2,000 3,000 4,000


Retirement Age People born prior to 1935 can retire at full

benefits at 65. People born between 1936 and 1942 can

retire at full benefits at age 65 + 2 months for every year after 1936 they were born.

People born between 1943 and 1954 can retire at full benefits at age 66.

People born between 1955 and 1960 can retire at full benefits at age 66 + 2 months for every year after 1955 they were born.

People born after 1960 can retire at full benefits at age 67.


Spousal and Dependent Benefits

.5 of PIA is added for a spouse and each dependent


Divorce and the Two-Income Family

The structure of the benefit formula is such that a woman who worked while married to a high income-earning husband will get nothing or virtually nothing for the taxes she paid. She and her husband would get 1.5 times his PIA if she earned nothing and 1.5 time his if she earned a modest income.

Divorced people are entitled to either their own PIA or half the amount that they would have received as a couple had they not divorced.


The Importance of Social Security Income to the Elderly

2/3 get more than half of their income from Social Security.

Private pensions only account for 18% of elderly income.


Cost-of-Living Adjustments

Benefits are adjusted for inflation using the CPI.

Because the CPI overstates inflation (by estimates in the neighborhood of 1.1 percentage points), this means that there are real increases in Social Security benefits each year.


How do Rates of Return Compare to Private Pensions

Between 1950 and 1975 the rate of return for

Social Security was around 10%.

It is predicted that the real rate of return will be around 2% in the future.

Private pensions have historically yielded from 5 to 10% over a similar period of time.


International Transfers

Not only does Social Security transfer income from those who are young to those who are old, it transfers income from the generation born after 1945 to the generation born before 1925. On average those born in between 1925 and 1945 will see approximately the same return they would have received in a similarly safe asset.


Demographic Changes

Birthrates have fallen such that the number of workers supporting each retiree has fallen from more than 30 in the 1950s to below 5 beginning in 1990. It is projected to be below 3 by 2030 and below 2 shortly thereafter.


Algebraic Look at the Result of Demographic Changes Under a Pay-as-You-Go system

t = (B × R)/(W × L)

Where:

t is total benefits paid

B is the average benefit

R is the number of recipients

W is taxable wages

L is the number of workers


Algebraic rearranging

t = B/W × R/L = the average replacement rate × the dependency ratio

The dependency ratio was below .1, it is currently above .3 and is steadily increasing and will be at .5 in 2030.


Year Basic OASDHI

Tax Rate

Combined Employer-

Employee Tax Rate

Maximum Taxable

Wages per Worker

Maximum Tax Based on Combined

Rate

1937 1.00 2.00 $3,000 $60.00

1957 2.25 4.50 $4,200 $189.00

1967 4.40 8.80 $6,600 $528.00

1977 5.85 12.10 $16,500 $1,930.50

1987 7.15 14.30 $43,800 $6,263.40

1997 7.65 15.30 $65,000 $10,006.20

2000 7.65 15.30 $76,200 $11,658.60


Proposals to Reform Social Security

Maintain benefits Increase taxability of benefits Invested Trust Fund in Corporate Securities Eventually increase payroll tax rate by 1.6 percentage points

Individual Accounts Raise the retirement age Reduce replacement rates for upper income people Allow 1.6 percent of payroll to be placed in special retirement

accounts Personal Security Accounts

Allow half of payroll taxes to be placed in individually managed accounts.

Reduce the guaranteed benefit


Impact of Social Security on Savings and Work Incentives

Income and Substitution Effects

The Substitution Effect leads to decreased saving and work.

The Income Effect may lead to an increase or decrease in savings and work. Most economists believe the income effect also decreases savings and work.


Figure 8.2 Social Security Pensions and the Work-Leisure Choice

C

A

G

B

L1 L2

E E'

0

B

$30

24

Inc

om

e p

er

Da

y

Leisure Hours per Day

24

$30

A

A

G B

0 4 9 19 14

U2 F

H

U2

U1


Working While Eligible for Social Security Benefits

People may work and receive Social Security benefits.

If they receive benefits with the reduced benefits option at age 62, they lose $1 in benefits for every $2 they earn more than approximately $10,000.

Those older than 65 may earn any amount and keep their benefits.

If they choose not to receive benefits, they receive a greater Social Security benefit when they decide to begin receiving them.


Savings Incentives of Social Security Asset Substitution Effect: People save less than they would

if Social Security did not exist because they are substituting government promises of a benefit for private savings. Stated simply, people save less because government is “saving” for them.

Induced Retirement Effect: People save more than they would if Social Security did not exist because they would not have retired or would not have retired as early had Social Security not been there. Given that it does exist, people choose to ultimately retire or retire earlier and save in order to do so.

Bequest Effect: People save more than they would have if Social Security did not exist in order to give more to the children and grandchildren when they die.


Figure 8.3 The Asset Substitution EffectC

on

su

mp

tio

n p

er Y

ea

r a

fte

r R

eti

rem

en

t

Consumption per Year Prior to Retirement

0

A

A

R

G

B

A

B C D 0

G2

R2 F

T

S

S

TS' BCD

Social Security Pension

Social Security Pension

U1

E

U2 U1

F E


The Net Effect of Social Security on Savings

Feldstein: Social Security leads to a substantial reduction in savings

Munnell: The net effect of the ASE, BE, and IRE is nearly zero


Medicare The program provides substantially subsidized

health insurance to those 65 and older. It is financed with premiums, a 2.9% payroll tax (1.45% on employers and employees) and general government revenue. Part A:

Mandatory Covers hospitalization Financed with payroll tax and premiums

Part B: Voluntary Covers doctor’s visits Financed from general federal revenue and premium


Unemployment Insurance

Covers nearly all full-time workers Financed with a payroll tax on

employers up to $7000 of earnings Gross Replacement Rate: 33%

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