Transcript Lecture12

Social Security
Today: From the origins of Social
Security to today’s structure; Long-run
problems due to the graying of America
Today: Social Security
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Some people rely on SS for a majority of their
income
How many of you pay less than $500 for rent
on an apartment?
Let’s see what $500 can rent in Memphis

Come to class to find out
Today
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We analyze another benefit that most seniors
receive
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Social Security (SS)
Questions
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How did Social Security begin?
What is today’s 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?
How did Social Security begin?
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SS, which is officially Old Age, Survivors, and
Disability Insurance, began in 1937
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White male work categories initially were covered
Coverage grew to more people over the next 50
years or so
Justification for SS
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What if I outlive my money?
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Indirectly transfers money from those that die young to
those that die old
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Directly, the transfer is from workers to retirees
Fully funded?
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Original idea involved having a large fund to
pay benefits out of
Political pressure turned SS into a pay-asyou-go system
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The current generation of workers pays for today’s
retirees
There has been some money in reserve
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Reserves projected to diminish starting in 2017
Fully Funded Plan
Period 1 Period 2 Period 3 Period 4
The Greatest
Generation
Work
contribute
The Baby Boom Childhood
Generation
Generation X
Unborn
Retire
Dead
Each generation’s
benefits
benefits based on
deposits it made during
Retire
Work
working life plus
accumulated interest
contribute
benefits
Childhood
Work
contribute
Still
Dead
Dead
Retire
benefits
Pay As You Go (or Unfunded) System
Period 1 Period 2 Period 3 Period 4
benefits
The Greatest
Generation
Work
Retire
contribute
benefits
The Baby Boom Childhood
Generation
Unborn
Generation X
Work
Each generation’s
Dead
Still
benefits come from
tax
Dead
payments made by
current workers
Retire
Dead
contribute
benefits
Childhood
Work
Retire
contribute
benefits
Projected revenues and payments of SS
In 2017, payments are projected
to exceed tax revenue
Growth of SS in the US
600
6
500
5
400
4
300
3
200
2
100
1
0
0
1937
1942
1947
1952
1957
1962
1967
1972
1977
1982
1987
Year
Real Expenditures (2006 $ Billions)
Expenditures as % of GDP
1992
1997
2002
Expenditures as % of GDP
Real Expenditures (2005 $ Billions)
Figure 11.1: Social Security expenditures (1937-2005)
How does SS work?
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Mostly pay-as-you-go, or unfunded, financing
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Financing
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Current workers pay, retirees receive
Retirement age
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Recall that some reserves exist
“Normal” age is gradually increasing
Benefit structure
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Based on average indexed monthly earnings
Financing
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In 2006, each of the first $94,200 was subject to SS taxes
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12.4%, evenly split between employee and employer
Note that Medicare financing is separate from SS
Taxes create illusion of obligation to future generations
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SS could be eliminated if the federal gov’t decided to do so
SS tax rates
over time
The Social Security Trust Fund
Worker
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Trust
Fund
Retiree
Money flow shown above
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Workers pay into the trust fund
Retirees receive money from the trust fund
Retirement age
Year of birth
1937 or earlier
Full retirement age
62 is minimum retirement age
(with reduction in benefits)
Months between age 62 and full
retirement age
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
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
67
60
1943-1954
1960 or later
Benefit structure
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Based off average indexed monthly earnings
(AIME)
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Top 35 years of wages, factored for inflation
2006 benefit formula: Primary insurance
amount (PIA)
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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
Benefit structure
PIA
2000
1800
1600
1400
1200
1000
800
600
400
200
0
First Bend Point
Second Bend Point
AIME
0
500
1000
1500
2000
2500
3000
3500
4000
4500
5000
5500
Long-run problems with SS
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Population growth in
some countries is
stagnating
Populations are getting
older on average
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Both problems are
putting pressure to do
at least one of the
following
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Decrease benefits
Increase the retirement
age
Increase SS taxes
A simple model
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Assume three equal periods of life
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Childhood
Working years
Retirement
Suppose that each generation is twice as big
as the previous one
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Twice as many workers as retirees
Workers pay less into SS than they receive when
they retire
Stagnation in population growth
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Population growth has stagnated in some
developed countries
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Example: Greece, 2007 estimates
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Current population growth is 0.16% per year
People are dying at a faster rate than births
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1.35 children born per woman’s childbearing years
Only positive net migration is keeping Greece’s population
from falling
(Source: http://en.wikipedia.org/wiki/Demographics_of_Greece)
Greek population
Thousands of people
Source:
http://en.wikipedia.org/wiki/
Demographics_of_Greece
Year
Graying of the population
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America is currently “graying” in two ways
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Americans are living longer
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Life expectancy
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Infant mortality
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1959-1961: 69.9 years
2004: 77.8 years
1959-1961: 2.6%
2004: 0.68%
Baby boom generation is beginning to retire
Statistics from Center for Disease Control and Prevention website
Graying of the population
Baby boom generation (roughly)
This graph
show the
number of
people aged
0-99 in 1999
6000000
5000000
Number of people
4000000
Series1
Series2
3000000
2000000
1000000
0
1
5
9
13
17
21
25
29
33
37
41
45
49
53
Age
57
61
65
69
73
77
81
85
89
93
97
Some possible solutions to SS problem
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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
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Some other possible
solutions
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Raise the maximum
taxable earnings level
Raise the retirement age
Reduce the cost-of-living
adjustment
Change the benefit
formula
A combination of options
Warning
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Secondary effects must be taken into account
with SS reform
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Be careful about increasing taxes
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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
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Could lead to lower wages for all workers
What will happen to SS?
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Over the next decade, one of several things
could occur to SS
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Nothing: Let the next generation solve the
problem
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Partly solve the problem
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Waiting too long could lead to social unrest
Current solvency: 30-40 years
Some proposals would increase this to 75 years
Fully solve the problem (not likely)
How do people change behavior with SS?
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With SS, people change their behavior in the
working years
We will examine the life-cycle theory of
savings
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Wealth substitution effect
Retirement effect
Bequest effect
Life cycle theory of savings
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People save and borrow based on planned
lifetime consumption
Somebody with diminishing MU prefers
smooth consumption over time
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Without SS, a rational person will save during the
working years and use this money for retirement
Future consumption (c1)
Budget constraint for present and future
consumption
N
D
(1+r)S
I1 + (1+r) S
At endowment
point consumer
neither saves nor
B borrows
I1
(1+r)B
F
S
I1 - (1+r) B
M
I0 - S
I0
Present consumption (c0)
Wealth substitution effect
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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
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Crowds out private saving
Known as the wealth substitution effect
Future consumption (c1)
Utility-maximizing choice of present and
future consumption
N
c1*
E1
A
I1
Saving
M
c0*
I0
Present consumption (c0)
Future consumption (c1)
Crowding out of private saving due to SS
N
E1
c1*
R
A
I1
(1+r)T
TSaving after
Saving before
Social Security
Social Security
M
c0*
I0T
I0
Present consumption (c0)
Retirement effect
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SS gives workers a financial incentive to
retire early
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Retirement effect states that people may save
more in their working years in order to have their
desired consumption during a longer retirement
period
Bequest effect
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Some people may feel guilty with the fact that
their children are financing their retirement
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Bequest effect states that people save more
during their working years to finance a larger
bequest to their children when they die
Summary
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SS is a big part of the US economy
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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
Next lecture: Parts of Chapters 12 and 13
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Distribution of income (I
will present this
differently than the
textbook)
Rationales for
redistribution
In-kind versus cash
transfers
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Various welfare
programs for the poor
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TANF
EITC
Supplemental Security
Income
Medicaid
Unemployment insurance
Problems
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Contributions to Social Security
Crowding out of private saving
Problem 1
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Contributing to Social Security
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Assume 2006 structure
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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…
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$40,000?
$80,000?
$120,000?
$160,000?
Problem 1
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Explicitly, the employee only pays half of the
tax
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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”
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6.2% of $94,200 is $5,840.40
Problem 2
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Crowding out private saving
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Assume two periods
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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
Problem 2
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What will consumption be in each period
without social security?
What happens if the government provides the
following social security system?
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$200,000 in SS taxes in period 1
$240,000 in SS payments in period 2
Problem 2: Case 1
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No social security
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Utility is c1c2
Constraint
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(1 + 0.2) c1 + c2 = $1,200,000
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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
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max c1c2 s.t. c2 = $1,200,000 – 1.2c1
Equivalent to max c1 (1,200,000 – 1.2c1)
Problem 2: Case 1
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Solve max 1,200,000c1 – 1.2c12
Set FOC equal to zero
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1,200,000 – 2.4c1 = 0
c1 = 500,000
The rest of consumption goes to period 2
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Save $500,000 of earnings in period 1
Add 20% interest (100,000)
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$600,000 consumption in period 2
Problem 2: Case 2
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What happens with SS system
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$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