Social Security

1
Social Security

• You PayI Play

2
What is Social Security

• The set of programs popularly known as Social
  Security actually has a far more imposing
  official designation Old Age, Survivors,
  Disability and Health Insurance, or OASDHI for
  short.
• Enacted as part of the Social Security Act of
  1935, social security was originally designed to
  provide only old-age or retirement benefits it
  was then known as OAI.
• Survivors benefits were added in 1939, and the
  system became OASI.
• In 1954 disability benefits were included, and
  the system was thus OASDI.
• In 1965, Medicare was enacted and the system
  evolved into OASDHI.
• Today social security is perhaps the most
  important, and certainly the largest, expenditure
  policy in the United States.

3
Social Insurance

• There are other social insurance programs besides
  OASDHI (items 1 and 2 above).
• Unemployment insurance was enacted at the same
  time as SS, but it is not financed out of social
  security payroll taxes.
• Veterans medical care is also financed separate
  from OASDHI.
• Can you think of a rationale for Social
  insurance?
• Adverse selection
• Paternalism
• Economize on decision-making costs
• Income redistribution

4
The Genesis of Social Security

• When Social Security was established in 1935, it
  was meant to satisfy two competing goals
  individual equity and social adequacy.
• The first goal could have been achieved if Social
  Security were established as a more conventional
  retirement program.
• In a so-called "fully-funded" system, individuals
  contribute a portion of their income to a trust
  fund during their working years, and a fund
  manager invests those funds for the benefit of
  all contributors.
• Upon retirement, each individual receives a
  pension based on the contributed amount plus
  earnings, adjusted on an actuarial basis.
• The fund would be obligated to pay a pension to
  all participants until their deaths.

5
Conventional retirement funds

• Most private pension programs are established on
  a sound actuarial basis.
• The term actuarial basis means that the pension
  fund is calculated to run out after a recipient
  has lived an expected life span.
• Those who live longer than the average age will
  be supported by funds that were set aside for
  those who died before reaching the average age.
• If survivor benefits are paid, it simply means
  that the expected life span of the surviving
  spouse is factored into the calculations.

6
Social Adequacy

• President Roosevelt rejected the idea of
  establishing an actuarially sound, fully-funded
  trust fund because it did not satisfy the social
  adequacy goal.
• First, low income participants would have great
  difficulty contributing enough of their income
  during the working years to have an adequate
  pension during retirement.
• Second, since contributions would have to be made
  over a person's working life-time, it would have
  been many years before the system had any effect.
  
• President Roosevelt wanted an almost immediate
  benefit by taking care of people who were within
  a few years of retirement.
• Under these constraints, there was no time for
  them to build up an account on which to draw.

7
The Pay-as-you-go System

• Because of these political considerations,
  President Roosevelt chose a method of finance
  whereby those currently working support those
  currently retired.
• Thus was born pay-as-you-go financing.
• Anyone who contributed to the system for at least
  5 years would be eligible to retire at age 65.
• Social Security was financed with a flat tax of
  2, levied on the first 2,000 for all workers.
  Both the rate and the wage base have increased
  substantially since 1935.
• The pay-as-you-go system, together with changing
  demographics, is the cause for todays social
  security crisis, in spite of the sharp rise in SS
  taxes.

8
Table 5-1Social Security Tax Rates and Tax
BasesSelected Years, 1934-2007
Year Tax Rate Tax Base 1934 2.0
2,000 1945 2.0 3,000 1950
3.0 3,000 1955 4.0
4,200 1960 6.0 4,800 1965
7.25 4,800 1970 9.6
7,800 1975 11.7 14,100 1980
12.3 25,900 1985 14.1
39,600 1990 15.3 51,300 2001
15.3 80,400 2003 15.3 87,000 2005
15.3 90,000 2007 15.3 97,500
In 1966, a portion of the SS tax was set aside
for Medicare. In 1993, the base for the Medicare
was eliminated. The Medicare tax is currently
2.9 of the total 15.3.
9
Inter vs. Intra generational transfers

• The pay-as-you-go financing of social security,
  together with the goal of social adequacy, has
  resulted in some interesting redistribution
  patterns.
• Income is redistributed both intergenerationalbet
  ween generationsand intragenerationalwithin a
  generation.
• To the extent that social security creates
  intragenerational transfers, it is a social
  welfare program.
• This transfer occurs because low income workers
  receive a larger rate of return on their SS taxes
  than do high income workers.
• The tax on high income earners is capped, but
  that same cap applies to benefits, in addition to
  having a lower payout formula at the high end of
  the income scale.

10
Intergenerational Transfers
Heres Ida!

• The intergenerational aspects of Social Security
  benefits are inevitable with a pay-as-you-go
  system.
• Workers who retired in the early years received a
  better deal than workers currently retiring and
  those who will retire in the future.
• This is because early retirees had not paid SS
  taxes over their entire working lives.
• For example, Ida Fuller of Brattleboro, Vermont,
  the first Social Security pension recipient,
  worked for three years under the Social Security
  program.
• The accumulated taxes on her salary during those
  three years was a total of 24.75.
• Her initial monthly check was 22.54.
• Ms. Fuller lived to the ripe old age of 99, after
  collecting a total of 22,888.92 in Social
  Security benefitsnot a bad return on 22!
• And so,

11
Another look at redistribution

• Table 9.3 gives you another look at the both
  inter and intra generational transfers.
• By reading across the chart, you will notice that
  intra generational transfers have gotten more
  significant over time.
• By reading down, you will notice that the same is
  true for inter generational transfers.

12
Other distributional issues

• Social Security redistributes income between
  generations, within generations, and in some
  rather arbitrary ways.
• Women gain more than men because of longer life
  expectancy.
• Married people with uncovered spouses gain more
  than single people.
• One couple earners gain more than two-earner
  couples.
• To the extent that women earn less than their
  husbands (and usually have fewer work years),
  this means, for many working women, that their
  taxes accrue little or no net benefit.
• Suppose a husband collects near the maximum
  benefit, say, 2000. If his wife had roughly half
  the earnings of her husband, her benefit would be
  about 1500.
• If she did not pay a single penny of social
  security taxes, she would still get 1000, i.e.,
  50 of her husbands benefit.
• The net family benefit from all her years of
  working and contributing is roughly 500 a month.

13
Average Indexed Monthly Earnings

• A worker becomes eligible for retirement benefits
  at age 62. The AIME is calculated at that point.
• If one retires at age 62, the monthly benefit
  will be reduced.
• If retirement is delayed, the monthly benefit
  will be higher.
• Lifetime earnings are indexed to reflect the
  change in general wage levels that occurred
  during a workers years of employment.
• The AIME is calculated by summing the years with
  the highest indexed earnings and dividing by the
  number of months in those years.
• This amount, the AIME, is then used in computing
  the primary insurance amount, which is equal to
  the monthly benefit paid at the normal retirement
  age.

14
Normal Retirement Age
Year of birth Normal retirement age 1937 and
prior 65 1938 65 and 2 months 1939 65
and 4 months 1940 65 and 6 months 1941 65
and 8 months 1942 65 and 10 months 1943-54
66 1955 66 and 2 months 1956 66 and 4
months 1957 66 and 6 months 1958 66 and 8
months 1959 66 and 10 months 1960 and later
67
15
The Primary Insurance Amount

• The primary insurance amount (PIA) is the benefit
  a person would receive if he/she retires at the
  normal retirement age.
• The PIA is the sum of three separate percentages
  of portions of average indexed monthly earnings
  (AIME).
• These dollar amounts, 606 and 3,653, are called
  the bend points of the PIA formula.
• For 2003, the PIA will be the sum of
• 90 percent of the first 606 of AIME, plus
• 32 percent of AIME over 606 and through 3,653,
  plus
• 15 percent of AIME over 3,653.
• No benefits are added for AIME over 7,250
  (87,000/12).
• These so called bend points are actually the
  marginal benefit ratios.
• As you can see, they are highly progressive in
  favor of low income individuals.

16
SS Benefit formula for 2003
Source Browning, Edgar K. and Browning,
Jacquelene M. Public Finance and the Price
System, 4th edition. Prentice Hall. 1994.

• The bend points can be seen clearly in the
  diagram.
• Line 0R represents a monthly benefit that is
  50 of AIME.
• The maximum benefit of 2060 would only be paid
  to a recipient who had income substantially above
  the cap for most of his working years.
• For income of 606, the replacement rate is 90.
• For income 7,250, the replacement rate is 28.4.
• As you can see, the system is highly progressive
  on the benefit side, as opposed to the tax side.

17
The Problem with Social Security

• With sixty years of hindsight, setting up Social
  Security on a pay-as-you-go, rather than an
  actuarially sound basis, was probably a bad idea.
• No one alive today had any responsibility for
  that decision, but for millions of American
  workers, there is a perception that the
  government owes them a pension in exchange for
  long years of paying social security taxes.
• It hardly seems right to call it an entitlement
  program, even though it contains an element of a
  social welfare program to low income recipients.
• Over time, the number of workers to support each
  retiree in this pay-as-you-go system has
  gradually diminished.
• In 1935, the ratio of workers to retirees was 20
  to 1. In 2003, that ratio had shrunk to 3 to 1.
• By the year 2030, the ratio will shrink to 2 to
  1.
• There are two demographic explanations for this
  phenomenon people are living longer, and a
  large baby boom generation will begin to retire
  in 2012.
• The longer life span accounts for the shrinking
  ratio for the first 75 years the baby boom
  generation accounts for its future shrinkage.

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Population Distribution

• Heres the picture in 1950. Notice the bulge.
  Anyone know what that is?
• Its your parents. Its called the baby boom.

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Population Distribution

• Now look at the bulge in 1989.
• The baby-boomers are in their prime working years.

20
Population Distribution

• Look what happens in 2030.
• The baby-boomers are now retired.
• Where are your parents?

• Where are you on this chart?
• Whos coming along to take care of you?

21
Social Security in Crisis

• There have been at least three major crises of
  confidence in the Social Security system since
  its inception.
• Each of these crises is associated with the
  pay-as-you-go method of finance, in conjunction
  with imprudent decisions to expand benefits.
• Although it was never intended that Social
  Security would have a conventional trust fund, it
  was always necessary to maintain a small
  contingency reserve to cover some limited number
  of months of pension benefits.
• In each crisis, the problem emerged when the
  reserve fund came perilously close to being
  exhausted.
• And, in each case, the first reaction was to
  raise revenues. (Also see.)
• There are two ways to increase Social Security
  revenues
• Increase the tax rate or increase the base on
  which that tax is collected.
• Every increase in the Social Security tax has
  been accomplished by a combination of these two
  factors.

22
The 1958 Crisis

• The first hint of crisis attributable to the
  pay-as-you-go system came in 1958.
• It was the culmination of a series of events that
  occurred many years earlier.
• In the original Social Security Act, the tax
  rates, although modest, were enough to create a
  sizable surplus in the reserve fund.
• This surplus was a result of impressive growth in
  both the size and productivity of the labor
  force, and it accumulated despite steady
  increases in the number of retirees.
• An amendment to the Act in 1939 deliberately
  scaled back the reserve fund, although it
  continued to grow.
• In the early 50's, those surpluses were a
  tempting target for the Congress, who voted
  several increases in benefits.
• By 1958, the economy was in recession and the
  situation changed dramatically, resulting in a
  crisis.
• The solution was a tax increase that was intended
  to get the system back on a sound actuarial
  basis, as described by Rep. Wilbur Mills, the
  Chairman of the powerful House Ways and Means
  Committee.

23
The 1977 Crisis

• The 1977 crisis was not entirely attributable to
  the pay-as-you-go system.
• The substantial inflation of the late 60s, early
  70s, had begun to erode the real purchasing
  power of everyone living on a fixed income,
  particularly retirees.
• In response, Congress raised benefits by 15 in
  1970, 10 in 1971, and 20 in 1972.
• These changes were meant to restore the real
  value of Social Security income, although they
  more than offset the losses due to inflation.
• To protect against future inflation, benefits
  were indexed in 1972 to rise with inflation
  beginning in 1975.
• But in their zeal to protect retirees from
  inflation, a slight glitch was included in the
  adjustment formula whereby inflation was double
  counted.
• Even though the error was detected well before
  the double indexing took effect in 1975, the
  formula was not corrected until 1977 when the
  crisis brought on the need for drastic action.

24
The 1977 Crisis(continued)

• Even as retirees were being over-compensated in
  the early 70s for the effects of inflation of
  the late 60s, there was little concern that this
  would precipitate a crisis.
• Unlike the 1958 crisis, growth in wages had more
  than kept pace with the increase in benefits and
  the growing number of retirees in the 60s.
• But with the 1974-75 recession, real wages of
  workers started to decline and continued to
  decline until 1983.
• It was within this context that the 1977 crisis
  brought on a 227b tax increase that was spread
  over the next several years.
• In addition to increasing both the rate and the
  base, the maximum taxable earnings were indexed,
  meaning that the tax would increase automatically
  each time average wages went up.
• In the wake of this fix, politicians fell all
  over themselves, taking credit for having dealt
  with the threatened bankruptcy, while Social
  Security officials predicted that the system
  would be sound until 2030.
• Unfortunately, the fix that was to last for
  more than half a century, lasted hardly half a
  decade.

25
The 1983 Crisis

• The question of Social Security solvency became a
  hot topic again in 1981, when President Reagan
  was faced with pending bankruptcy of the Social
  Security Trust Fund.
• Although benefits did not rise substantially
  beyond adjustments for inflation following the
  1977 fix, the tax increases levied then were not
  sufficient to keep up with the growth of
  retirees, and the horrible performance of the
  economy in the late 70's.
• In response to the 1983 crisis, Congress once
  again increased Social Security taxes by
  increasing both the tax rate and the wage base.
• To avoid the political fall-out of one of the
  most massive tax increases in history, the
  politicians scheduled tax increases to take place
  over the next seven years.
• The 1983 Social Security tax increases were a
  politicians dream because all of the blame was
  absorbed at one moment in time, while the pain
  was spread over many years.
• Who in 1990, could be blamed for tax increases
  that were enacted in 1983?

26
The 1983 Crisis(continued)

• While this period is much touted for the
  substantial cuts in the federal income tax
  brought on by the Reagan Administration, the
  increases in Social Security taxes more than
  offset those cuts, and it did so in a manner that
  was largely invisible to the average taxpayer.
• The reforms of 1983 also provided for some minor
  benefit reductions.
• The retirement age was gradually raised until it
  reached 67 in the year 2022.
• A portion of SS benefits became taxable for
  certain high income recipients.
• Prior to 1983, Social Security benefits were not
  taxable.
• Under the 1983 amendment, half of the benefits
  were taxable for individuals with incomes above
  25,000 and couples above 32,000.

27
The 1983 Crisis(continued)

• Mr. Clinton, in his 1992 deficit reduction
  program, raised the cutoff for tax-free SS as
  follows
• SS benefits are tax-free if combined income is
  less than 25,000 (single) and 32,000 (married
  filing jointly).
• No more than half of SS benefits can be taxed if
  combined income is between 25,000 and 34,000
  (single) or between 32,000 and 44,000 (married
  filing jointly).
• Up to 85 of benefits can be taxed if combined
  income is more than 34,000 (single) or 44,000
  (married filing jointly).
• The Republicans of the 104th Congress vowed to
  repeal that increase, but so far, no such repeal
  has been made.
• While this provision affected only about 20 of
  retirees in 1992, these thresholds were not
  indexed, and a larger number of retirees are
  feeling the effects today.
• The most significant change to come out of the
  1983 crisis was the deliberate increase in tax
  rates, above the level needed to maintain the
  pay-as-you-go status of the fund.

28
Implications of 1983 Tax Increases

• Current workers are paying not only for current
  retired persons, but they are also contributing
  to their own retirement.
• The purpose of this change is noble it is to
  preclude the massive tax increases on future
  generations that would be needed to pay for the
  baby-boom generation when they retire.
• In essence, the system is now a hybrid of a
  pay-as-you-go method of financing and a trust
  fund.
• We will return to this topic when we discuss the
  Feldstein proposal below.
• Because current workers are paying for current
  retirees, in addition to paying for a part of
  their own retirement, any proposal to cut
  benefits for future retirees would have a
  significant redistribution effects
• Pay more now.
• Receive less later.
• The generation of workers starting in 1983 will
  bear the brunt of political miscalculations of
  the past.

29
The Next Crisis

• The next crisis is not expected this year, or
  even for the next several years, so there is no
  need for panic, Right?
• Wrong! The longer we delay action, the more
  difficult the problem will be.
• Unfortunately, for a politician, playing with
  social security is like playing with fire.
• Ronald Reagan learned that in a big way in the
  midterm elections of his first term.
• Bill Clinton toyed with tackling the SS problem,
  but nothing was done.
• In May 2001, President Bush set up the
  President's Commission to Strengthen Social
  Security.
• Unfortunately, very little has been said about
  the problem since.
• But if there are no changes in the current
  structure of Social Security, the next crisis
  will surely come in the 2020-2030 decade when,
  according to the experts, most of the baby boom
  generation is retired.
• Take a look at the ideas of a very prominent
  economists on the burden we pass on to future
  generations http//www.townhall.com/columnists/Wa
  lterEWilliams/2005/11/02/do_we_really_care_about_c
  hildren
• I believe my proposal presented below will help
  to avert the next crisis.

30
Proposals to Reform Social Security

• There have been numerous proposals to reform
  Social Security over the past several decades.
• We will discuss two of the more prominent
  arguments, in addition to an alternative that I
  worked out several years ago.
• My approach is not uniqueit includes numerous
  ideas put forth by others.
• I am also a big fan of privatizing social
  security, but I have not worked out the details
  of a proposal.
• If you are interested in privatization, go to
  Google and type in social security in Chile.
• The two proposals below have become, almost
  generic, since they represent the polar extremes
  of eliminating the system on one hand, and
  converting it to an actuarially sound trust fund
  on the other.
• I will discuss these proposals because they were
  advanced by two economists of impeccable
  credentials, and because most other proposals are
  only slight variations from these basic themes.

31
The Friedman Proposal

• In 1972, Milton Friedman set forth a proposal to
  phase out Social Security altogether, over
  several years.
• His rationale for such a drastic change is quite
  simple
• He sees Social Security as an infringement on
  individual freedom because it requires people to
  provide for their retirement in a manner and on
  terms over which they have no control.
• This theme has been repeated several times,
  including a proposal by Ronald Reagan before he
  became President.
• Friedman's plan would freeze all benefits at some
  point in time.
• Benefits accumulated up to that point would be
  paid when individuals retire, but no further
  benefits would accrue.
• The government would continue to collect taxes to
  pay current retirees and to pay the reduced
  benefits of those caught in the transition.
• Young people just entering the labor force would
  receive no benefit they would be on their own
  hook to provide for retirement.
• Social Security taxes would gradually decline as
  current retirees die and are replaced by those in
  the transition who retire with lower benefits.
• In 50 or 60 years, all obligations under the
  system would be paid and the tax would be
  eliminated altogether.

32
The Feldstein Proposal

• The Feldstein proposal, first advanced in 1975,
  took the opposite tact from Friedman.
• Feldstein disagreed with the radical reformers
  who would abolish our Social Security system on
  the grounds that it interferes with each
  individual's freedom to decide how much to save
  for his old age.
• Feldstein's proposal is based on the fact that
  Social Security has a severe negative effects on
  the rate of saving, and therefore capital
  formation.
• If we invest less in capital, the economy grows
  more slowly, and society as a whole has a lower
  standard of living.
• In a word, Social Security is inefficient.
• Most economists agree with this assessment, and
  most would agree in principle with a proposal to
  increase the saving rate.
• Feldstein proposed to convert Social Security to
  an actuarially sound trust fund.
• By increasing taxes and building a large trust
  fund, without increasing benefits, it would be
  possible make the transition over a period of 50
  or 60 years.
• As the trust funds builds, interest accumulates,
  thus reducing the need for future taxes.
• The 1983 tax increases are consistent with
  Feldstein's proposal, although they are
  inadequate to make the transition complete.

33
Winners and Losers in the Social Security Lottery

• It would be very difficult to detail all of the
  winners and losers in the great Social Security
  experiment.
• The establishment of the system in 1935 created
  generations of winners and losers that extend
  from the first recipients to generations unborn.
• By the same token, each change or proposal to
  change also creates winners and losers.
• Economists generally agree on a few of the more
  obvious examples stemming from the initial
  decision to use pay-as-you-go financing
• Retirees in the early years gained at the expense
  of later generations.
• Low income individuals gained at the expense of
  high income individuals.
• Everyone lost as a result of Social Security's
  negative effect on saving and thus investment in
  capital formation.
• The 1983 reforms created winners and losers.
• Future generations gained at the expense of those
  now working, because current workers are caught
  in a system that is both pay-as-you-go and trust
  fund.
• Current workers not only support the present
  retired generation, but they are financing part
  of their own retirement, thus reducing the tax
  burden on future generations.

34
Winners and Losers(continued)

• Reforming Social Security, whether the Friedman
  or the Feldstein proposal, produces some
  interesting win/lose results.
• Oddly enough, although their proposals are poles
  apart, the economic winners and losers are the
  same.
• Those currently young and future generations gain
  because both of the Friedman and the Feldstein
  proposals would significantly increase saving.
• The big losers in both cases are those currently
  working, who must continue to pay taxes, without
  gaining any further benefit.
• It is because of the magnitude and scope of
  winners and losers that it is so difficult to
  reform Social Security.
• The modest proposal presented below does not
  generate large groups of losers, nor does it
  create the winners who would benefit from
  increased saving.
• It does, however, maintain the benefit now
  expected by every working American, and it avoids
  passing a massive obligation on to the workers of
  the 21st century.
• It also transforms Social Security to a true
  retirement program by transferring the social
  welfare obligation to the Treasury.

35
A Proposal to Reform SS

• Because of the contractual nature of Social
  Security, my proposal does not require reducing
  payments to anyone below what is now presently
  scheduled.
• Because the future integrity of the system is in
  doubt, I believe a reasonable approach would be
  to redefine the system, whereby its sole
  objective would be to provide a retirement income
  that achieves individual equity.
• In other words, pay each retiree a fixed rate of
  return on their contributionsinsuring at least a
  positive rate of return.

36
A Proposal to Reform SS(continued)

• Since the social adequacy goal entails a program
  of income redistribution, those who do not
  receive some threshold level of income,
  comparable to what they get under the current
  system, would be eligible for additional payments
  from the general fund.
• For example, the Supplemental Security Income
  program could means test all retirees whose
  Social Security pension and income from other
  sources do not bring them to the threshold level
  of income.
• In essence, this plan reduces Social Security
  outlays, not by reducing benefits, but by
  transferring the welfare component of the system
  to the general fund, financed by taxes from all
  sources, rather than the payroll tax.

37
A Proposal to Reform SS(continued)

• The social welfare function now attached to
  Social Security would become an obligation of the
  Treasury, although payments would continue to be
  made by the Social Security Administration as
  part of SSI.
• The use of SSI as a vehicle for maintaining the
  social adequacy goal of Social Security
  introduces some interesting possibilities for
  streamlining other welfare payments to the
  elderly.
• For example, the elderly, as well as all other
  welfare recipients, are eligible for a patchwork
  of social welfare programs.
• Considerable administrative costs could be saved
  by consolidating all these payments into SSI, for
  the elderly only.

38
A Proposal to Reform SS(continued)

• Since the elderly rarely have child dependents,
  and since the chances of fraud and abuse are much
  less likely with them than with any other group,
  a single cash payment, consisting of social
  security retirement, SSI, and other welfare
  payments, would be a very cost-effective
  alternative.
• Benefits such as food stamps, fuel assistance,
  and housing subsidies could be incorporated into
  the single monthly check of any retired person
  whose retired income falls below a prescribed
  level.
• Since the elderly, by definition, do not work,
  then cash payments would not distort the decision
  to trade off leisure for income, i.e., no
  substitution effect, thus no welfare loss.

39
What if?

• I started work in 1964, the year Barry Goldwater
  proposed eliminating Social Security.
• I asked myself the question, what if Goldwater
  had won and SS was eliminated.
• I then took all my SS contributions from 1964 to
  1998, and extrapolated until my normal retirement
  date.
• I calculated the retirement fund I could
  accumulate, given various rates of return.
• Here are the results.

Now look at Social Security
40
Unemployment Insurance

• Since UI is a minuscule program compared to
  Social Security, I will just hit the highlights.
• What is it?
• The adverse selection problem.
• What is moral hazard, and how does it affect UI?
• What are the benefits?
• How is it financed?
• What does experience rated mean?
• Why is the experience rating system described as
  imperfect.
• Does UI increase the unemployment rate?
• Probably so.
• Is that good or bad?

41
Any Questions

• Next Topic Health Care

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