Social Security

1
Social Security

• Today From the origins of Social Security to
  todays structure Long-run problems due to the
  graying of America

2
Today Social Security

• Some people rely on SS for a majority of their
  income
• How many of you pay less than 500 for rent on an
  apartment?
• Lets see what 500 can rent in Memphis
• Come to class to find out

3
Today

• We analyze another benefit that most seniors
  receive
• Social Security (SS)
• Questions
• How did Social Security begin?
• What is todays structure?
• How is the graying of America affecting SS?
• How do we solve the long-run challenges to SS?
• How do people change their behavior with the
  implementation of SS?

4
How did Social Security begin?

• SS, which is officially Old Age, Survivors, and
  Disability Insurance, began in 1937
• White male work categories initially were covered
• Coverage grew to more people over the next 50
  years or so
• Justification for SS
• What if I outlive my money?
• Indirectly transfers money from those that die
  young to those that die old
• Directly, the transfer is from workers to retirees

5
Fully funded?

• Original idea involved having a large fund to pay
  benefits out of
• Political pressure turned SS into a pay-as-you-go
  system
• The current generation of workers pays for
  todays retirees
• There has been some money in reserve
• Reserves projected to diminish starting in 2017

6
Fully Funded Plan
Period 1 Period 2 Period 3 Period 4



The Greatest Generation
Work
Retire
Dead
StillDead
Each generations benefits based on deposits it
made during working life plus accumulated interest
The Baby Boom Generation
Retire
Work
Dead
Childhood
Unborn
Work
Childhood
Retire
Generation X
7
Pay As You Go (or Unfunded) System
0
Period 1 Period 2 Period 3 Period 4



Work
Retire
Dead
StillDead
Each generations benefits come from tax payments
made by current workers
The Greatest Generation
Work
Retire
Childhood
Dead
The Baby Boom Generation
Unborn
Work
Childhood
Retire
Generation X
benefits
8
Projected revenues and payments of SS
In 2017, payments are projected to exceed tax
revenue
9
Growth of SS in the US
10
How does SS work?

• Mostly pay-as-you-go, or unfunded, financing
• Recall that some reserves exist
• Financing
• Current workers pay, retirees receive
• Retirement age
• Normal age is gradually increasing
• Benefit structure
• Based on average indexed monthly earnings

11
Financing

• In 2006, each of the first 94,200 was subject to
  SS taxes
• 12.4, evenly split between employee and employer
• Note that Medicare financing is separate from SS
• Taxes create illusion of obligation to future
  generations
• SS could be eliminated if the federal govt
  decided to do so

SS tax rates over time
12
The Social Security Trust Fund
0

• Money flow shown above
• Workers pay into the trust fund
• Retirees receive money from the trust fund

13
Retirement age
62 is minimum retirement age (with reduction in
benefits)
Year of birth Full retirement age Months between age 62 and full retirement age
1937 or earlier 65 36
1938 65 and 2 months 38
1939 65 and 4 months 40
1940 65 and 6 months 42
1941 65 and 8 months 44
1942 65 and 10 months 46
1943-1954 66 48
1955 66 and 2 months 50
1956 66 and 4 months 52
1957 66 and 6 months 54
1958 66 and 8 months 56
1959 66 and 10 months 58
1960 or later 67 60
14
Benefit structure

• Based off average indexed monthly earnings (AIME)
• Top 35 years of wages, factored for inflation
• 2006 benefit formula Primary insurance amount
  (PIA)
• 90 of first 656 of AIME, plus
• 32 of AIME between 656 and 3,955
• 15 above 3,955
• Cap on benefits based on maximum taxable earnings
  subject to SS payroll tax

15
Benefit structure
PIA
First Bend Point
Second Bend Point
AIME
16
Long-run problems with SS

• Population growth in some countries is stagnating
• Populations are getting older on average

• Both problems are putting pressure to do at least
  one of the following
• Decrease benefits
• Increase the retirement age
• Increase SS taxes

17
A simple model

• Assume three equal periods of life
• Childhood
• Working years
• Retirement
• Suppose that each generation is twice as big as
  the previous one
• Twice as many workers as retirees
• Workers pay less into SS than they receive when
  they retire

18
Stagnation in population growth

• Population growth has stagnated in some developed
  countries
• Example Greece, 2007 estimates
• Current population growth is 0.16 per year
• People are dying at a faster rate than births
• 1.35 children born per womans childbearing years
• Only positive net migration is keeping Greeces
  population from falling

(Source http//en.wikipedia.org/wiki/Demographic
s_of_Greece)
19
Greek population
Source http//en.wikipedia.org/wiki/Demographics
_of_Greece
Thousands of people
Year
20
Graying of the population

• America is currently graying in two ways
• Americans are living longer
• Life expectancy
• 1959-1961 69.9 years
• 2004 77.8 years
• Infant mortality
• 1959-1961 2.6
• 2004 0.68
• Baby boom generation is beginning to retire

Statistics from Center for Disease Control and
Prevention website
21
Graying of the population
Baby boom generation (roughly)
This graph show the number of people aged 0-99 in
1999
22
Some possible solutions to SS problem

• In order to have sustainable solvency of the SS
  system in the US, additional financing equivalent
  to a 3.5 percentage point increase in the payroll
  tax must be achieved

• Some other possible solutions
• Raise the maximum taxable earnings level
• Raise the retirement age
• Reduce the cost-of-living adjustment
• Change the benefit formula
• A combination of options

23
Warning

• Secondary effects must be taken into account with
  SS reform
• Be careful about increasing taxes
• In Chapter 15, we will see that tax increases can
  cause other problems in the economy
• Increasing the retirement age could increase the
  supply of workers
• Could lead to lower wages for all workers

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What will happen to SS?

• Over the next decade, one of several things could
  occur to SS
• Nothing Let the next generation solve the
  problem
• Waiting too long could lead to social unrest
• Partly solve the problem
• Current solvency 30-40 years
• Some proposals would increase this to 75 years
• Fully solve the problem (not likely)

25
How do people change behavior with SS?

• With SS, people change their behavior in the
  working years
• We will examine the life-cycle theory of savings
• Wealth substitution effect
• Retirement effect
• Bequest effect

26
Life cycle theory of savings

• People save and borrow based on planned lifetime
  consumption
• Somebody with diminishing MU prefers smooth
  consumption over time
• Without SS, a rational person will save during
  the working years and use this money for
  retirement

27
Budget constraint for present and future
consumption
N
D
At endowment point consumer neither saves nor
borrows
Future consumption (c1)
(1r)S
I1 (1r) S
B
I1
(1r)B
F
S
I1 - (1r) B
M
Present consumption (c0)
I0
I0 - S
28
Wealth substitution effect

• Along the budget constraint, suppose I am forced
  to have 1 less today and (1 r) more in future
  consumption
• This will lead to 1 less in saving today
• Crowds out private saving
• Known as the wealth substitution effect

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Utility-maximizing choice of present and future
consumption
N
Future consumption (c1)
E1
c1
A
I1
Saving
M
c0
Present consumption (c0)
I0
30
Crowding out of private saving due to SS
N
Future consumption (c1)
E1
c1
R
A
I1
(1r)T
Saving before Social Security
T
Saving after Social Security
M
I0
c0
I0T
Present consumption (c0)
31
Retirement effect

• SS gives workers a financial incentive to retire
  early
• Retirement effect states that people may save
  more in their working years in order to have
  their desired consumption during a longer
  retirement period

32
Bequest effect

• Some people may feel guilty with the fact that
  their children are financing their retirement
• Bequest effect states that people save more
  during their working years to finance a larger
  bequest to their children when they die

33
Summary

• SS is a big part of the US economy
• About 4.25 of GDP
• Private saving likely changes when SS is
  introduced
• An idea of fully-funded SS system turned into a
  pay-as-you-go system
• Reforms will need to be made in order to make SS
  solvent for your retirement

34
Next lecture Parts of Chapters 12 and 13

• Distribution of income (I will present this
  differently than the textbook)
• Rationales for redistribution
• In-kind versus cash transfers

• Various welfare programs for the poor
• TANF
• EITC
• Supplemental Security Income
• Medicaid
• Unemployment insurance

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Problems

• Contributions to Social Security
• Crowding out of private saving

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Problem 1

• Contributing to Social Security
• Assume 2006 structure
• Earnings taxed up to 94,200
• 12.4 tax rate, split evenly between employee and
  employer
• How much is paid by employee if earnings are
• 40,000?
• 80,000?
• 120,000?
• 160,000?

37
Problem 1

• Explicitly, the employee only pays half of the
  tax
• 6.2
• 6.2 of 40,000 is 2,480
• 6.2 of 80,000 is 4,960
• For the last two incomes listed on the previous
  page, the employee maxes out
• 6.2 of 94,200 is 5,840.40

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Problem 2

• Crowding out private saving
• Assume two periods
• Working years (period 1)
• Retirement years (period 2)
• Real interest rate of 20 between two periods
• Earnings of 1,000,000 in period 1, 0 in period
  2
• Utility is product of consumption in each period

39
Problem 2

• What will consumption be in each period without
  social security?
• What happens if the government provides the
  following social security system?
• 200,000 in SS taxes in period 1
• 240,000 in SS payments in period 2

40
Problem 2 Case 1

• No social security
• Utility is c1c2
• Constraint
• (1 0.2) c1 c2 1,200,000
• Equivalent to 1,000,000 consumed in period 1,
  1,200,000 consumed in period 2, or a linear
  combination
• Same as c2 1,200,000 1.2c1
• Solution
• max c1c2 s.t. c2 1,200,000 1.2c1
• Equivalent to max c1 (1,200,000 1.2c1)

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Problem 2 Case 1

• Solve max 1,200,000c1 1.2c12
• Set FOC equal to zero
• 1,200,000 2.4c1 0
• c1 500,000
• The rest of consumption goes to period 2
• Save 500,000 of earnings in period 1
• Add 20 interest (100,000)
• 600,000 consumption in period 2

42
Problem 2 Case 2

• What happens with SS system
• 200,000 of saving gets diverted to SS system
• Implicit 20 return when retired
• Same outcome as in Case 1, except 300,000 is
  saved instead of 500,000