Chapter 9 Social Insurance and Unemployment Insurance

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Chapter 9 Social Insurance and Unemployment
Insurance

• We all choose to, or at times have to, purchase
  insurance.
• Social insurance is a name give to the government
  programs that replace income losses that arise
  beyond the control of a person.
• Typically, the participation to these programs is
  compulsory Eligibility and benefits depend, in
  part, to the past contributions.
• A. Why Need Social Insurance? Adverse Selection
• Private insurance companies provide annuities to
  a group of people. These provide income in the
  event of disablement. As long as the group is
  sufficiently large, the risk the insurance
  company takes is not prohibitive.
• However, the story is different for individuals
  who cannot join a large group. Usually, those who
  have a high demand for insurance are those that
  will need it in the near future. For example, an
  individual with a high risk of heart disease will
  be willing to pay a lot for insurance.
• The insurance company cannot differentiate
  between a high or low risk person. If they charge
  a certain level of premium, only individuals with
  high risk will purchase insurance (Adverse
  selection). The company cannot pool risks. This
  drives the premiums for individual insurance
  inefficiently high.
• Social insurance solves this problem forces
  everybody into one big group.
• B. Social Security (SS)
• The largest expenditure program.
• During the working lives, individuals make
  contributions.

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• Once retired, the individual receives benefits
  based, partly, on the contributions.
• SS started as a fully funded system in 1935
  contributions were put into a fund and the
  principal yield was used to finance the
  benefits later.
• In 1939, SS was converted to pay-as-you-go
  basis current benefits are funded by current
  contributions.
• The baby-boom generation of post-WW II implies
  that the contributions will eventually be too
  small to finance all benefits.
• Thus, in 1983, the SS started to collect large
  surpluses in the Social Security Fund.
• Benefit Structure Benefits depend on earnings
  history, age, and some other attributes.
• First, the average monthly earnings (AIME) is
  calculated. The primary insurance amount (PIA) is
  equivalent to 90 of the first 561 of AIME, 32
  of AIME between 561 3,381, 15 of AIME in
  excess of 3,381. So a person with an AIME of
  661 would receive a PIA of (561)0.90
  (100)(0.32) 537.
• Second, an individuals actual benefit depends
  not only on PIA but also on the age of retirement
  and recipients family structure.
• Third, benefits may be subject to federal income
  tax as long as the person has earned an average
  yearly income of at least 34,000. Also, the
  benefits are adjusted for inflation.
• Financing SS is funded by a flat payroll tax up
  to a certain amount of wages. Half the tax is
  paid by employees and half by the employers.
• Note, however, that the employer may be able to
  shift the tax onto the employee by offering a
  lower wage.
• Why not use general tax revenues to finance SS?

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• Distributional Issues SS does a bit more than
  simply insurance. If providing insurance was the
  primary goal, then each individual would receive
  an actuarially fair return benefits would equal
  the (inflation adjusted) contributions.
• Indeed, SS redistributes income according to
  average lifetime income Higher income
  individuals receive a smaller percentage of their
  income as benefits than low income people. We say
  that lower income people gain more than higher
  income people.
• Also, women gain more than men since they live
  and receive benefits longer.
• Married people with uncovered spouses gain more
  than single individuals. Also, one earner couples
  gain more than two earner couples.
• Status of the Aged Has SS reached its purpose of
  maintaining the income of older people relatively
  constant?
• The current statistics seem to reply
  affirmatively. In 1970s about 25 of the elderly
  was below the poverty line whereas in 1999 this
  dropped to just under 10.
• C. Effects on Economic Behavior
• Working people may view SS taxes as a form saving
  and may save less privately (Substitution
  Effect). With a partially funded system, this
  means that public saving is less than the
  decrease in private saving. This reduces the
  total amount of capital accumulated.
• Working in the opposite direction, people may
  save more since they expect to retire earlier
  (Retirement Effect).
• Older workers may save more to undo the effects
  of SS on their working children by leaving more
  in bequests (Bequest Effect).

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• Which one of the three dominates can be
  identified by empirical research. In a recent
  paper, Feldstein 1996b found that substitution
  effect dominates the other two, such that SS
  reduces saving. This result, however, is
  contested. Other authors have found that SS might
  have actually increased saving.
• D. Social Security Reform
• As noted earlier, SS faces financial problems in
  the upcoming years. Also, are the economic
  effects significant?
• Maintain the Current System Proponents of this
  idea maintain that SS is a popular system and
  should not be changed too much, with the
  exception of increases in SS payroll taxes, etc.
• Opponents point to the redistributional
  implications and state that balancing the system
  implies large increases in payroll taxes.
• Privatization of SS This is really a modern name
  for fully funded system. Some claim that there
  will be no adverse effects on capital
  accumulation since all savings are invested into
  various financial assets, mutual funds, etc.
• This may not be necessarily true. Under current
  system (partially funded), SS funds are kept in
  form of government bonds. A privatized system
  would imply that government will have to find
  alternative means of finance. At the end, all
  that takes place may be a swap of private and
  public securities, without any increase in
  saving.
• E. Unemployment Insurance (UI)
• In 2000, 7.2 M people were covered with average
  weekly benefit of 213.
• Why should insurance against unemployment be
  provided socially?

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• The answer, as before, is adverse selection.
  Consequently, private firms attempting to offer
  private UI may have to charge high premiums.
• Moreover, once an individual gets a private UI,
  he/she may shirk at work, which may lead to
  unemployment, or will not spend all his effort to
  find a job, if already unemployed (Moral Hazard).
  
• While a compulsory government UI program
  eliminates the adverse selection problem, moral
  hazard problem cannot be reduced in this way.
• Is moral hazard empirically important? Most work
  finds that UI increases the duration of
  unemployment, though theres a wide discussion
  about whether this is a bad or good thing. Some
  argue that UI may imply a better match between
  firms and workers.
• Also, theres space for further policy to
  increase incentives to find work within the
  current UI system.