Transcript The Role of Government in the American Economy

CHAPTER
20
Social Security
PUBLIC SECTOR ECONOMICS: The Role of Government in the American Economy
Randall Holcombe
Social Security
Largest redistribution program
 Established in 1935, expanded in 1956
and 1965
 Paid for by earmarked payroll tax
 Pay-as-you-go program
 Taxes and benefits have continually risen

PUBLIC SECTOR ECONOMICS: The Role of Government in the American Economy
Randall Holcombe
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Social Security Payroll Tax
Established to function as governmentoperated retirement program
 No need-based requirement to collect
transfer
 Eligibility contingent on having
contributed to program in past

PUBLIC SECTOR ECONOMICS: The Role of Government in the American Economy
Randall Holcombe
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Contributions
In form of payroll tax
 Income taxed at constant rate up to
specified maximum level
 Employer/employee contribute equal
amounts
 Increase in tax rates and maximum wage
that can be taxed

PUBLIC SECTOR ECONOMICS: The Role of Government in the American Economy
Randall Holcombe
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Contributions
Table 20.1 Charac teristic s of the Soc ial Sec urity Program for Selec ted Years
Year
Combined Employer
and Employee Tax
Rates
Maximum Taxable
Inc ome
Soc ial Sec urity as a
Perc entage of Total
Federal Expenditures
1940
2.00%
$3,000
0.6%
1950
3.00%
$3,000
2.5%
1960
6.00%
$4,800
12.6%
1970
8.40%
$7,800
15.5%
1980
12.26%
$25,900
20.0%
1990
15.30%
$51,300
19.8%
2000
15.30%
$76,200
22.9%
2004
15.30%
$87,900
22.4%
Note: Tax rates are for Soc ial Sec urity and Medic are. Beginning in 1994 all
inc ome above the Soc ial Sec urity maximum taxable inc ome is taxed 2.9
perc ent for Medic are.
Sourc e: Statistic al Abstrac t of the United States , various issues.
PUBLIC SECTOR ECONOMICS: The Role of Government in the American Economy
Randall Holcombe
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Structure of the Tax
Social security payroll tax more than 39%
of total federal taxes
 Adheres to benefit principle
 Criticized on regressive nature

PUBLIC SECTOR ECONOMICS: The Role of Government in the American Economy
Randall Holcombe
20-6
Burden of Payroll Tax

Tax Shifting and Payroll Tax
 Wages
set by supply and demand
 Who pays tax irrelevant to after-tax income
of employee
PUBLIC SECTOR ECONOMICS: The Role of Government in the American Economy
Randall Holcombe
20-7
Visibility of Payroll Tax
Tax levied on employer will be hidden
from employee
 Easy for taxpayers to estimate their share
of cost to social security program

 Double
amount shown on W-2 form
PUBLIC SECTOR ECONOMICS: The Role of Government in the American Economy
Randall Holcombe
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Coverage
More than 90% of workers in paid
employment are covered by social
security program
 Eligibility

 Must
have worked for 40 quarters in a
covered job
 Benefits paid do not reflect present value of
past contributions
PUBLIC SECTOR ECONOMICS: The Role of Government in the American Economy
Randall Holcombe
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Redistributive Nature of
Program
Reasons social security is compulsory:
 Adverse selection

 Low
earners get paid more in proportion to
social security taxes than high earners
 Those who do not fare well likely to bypass
system

Pay-as-you-go system
 Requires
solvent
new contributors to keep system
PUBLIC SECTOR ECONOMICS: The Role of Government in the American Economy
Randall Holcombe
20-10
Pay-As-You-Go System of
Financing
Collects contributions from current
workers, redistributes them to current
retirees as benefits
 Current contributions not invested
 Dependent on new individuals entering
system
 Liabilities of social security system
unfunded

PUBLIC SECTOR ECONOMICS: The Role of Government in the American Economy
Randall Holcombe
20-11
Viability of Pay-As-You-Go
More new contributors entering system
each generation
 Affected by increasing benefit payments
 Affected by demographic factors:

 Population
living longer
 Baby
boom
 People have fewer children
PUBLIC SECTOR ECONOMICS: The Role of Government in the American Economy
Randall Holcombe
20-12
Political Determination of
Benefits and Costs
Expect rate of return on contributions to
equal growth in national income
 Program subject to change through
political process
 In self-interest for older generation to
vote for higher taxes in exchange for
higher benefits

PUBLIC SECTOR ECONOMICS: The Role of Government in the American Economy
Randall Holcombe
20-13
Social Security and Capital
Accumulation
Reduces incentive for private saving
 Funded Pensions

 Funds
from pension substitute for private
saving
 No net effect on aggregate investment

Unfunded Pensions
 Reduction
in amount of investment
PUBLIC SECTOR ECONOMICS: The Role of Government in the American Economy
Randall Holcombe
20-14
Social Security and Capital
Accumulation
PUBLIC SECTOR ECONOMICS: The Role of Government in the American Economy
Randall Holcombe
20-15
The Growth of the Social
Security Program

Original tax was combined rate of 2
percent on income up to $3,000 annually
 Today
is 15.3 percent on income up to
$84,900

In 1950, expenditures equaled 7.5
percent of assets
 Today,
32.3 percent of assets
PUBLIC SECTOR ECONOMICS: The Role of Government in the American Economy
Randall Holcombe
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Social Security as an
Investment

Social security as good investment
depends on:
 Structure
of future system
 Future tax rates
 Higher rates imply higher benefits
 Growth of future income in country
PUBLIC SECTOR ECONOMICS: The Role of Government in the American Economy
Randall Holcombe
20-17
Future of Social Security
Will pay out more in benefits than it
receives in revenues within a few
decades
 Possibility of tax increases
 Possibility of benefit cuts

PUBLIC SECTOR ECONOMICS: The Role of Government in the American Economy
Randall Holcombe
20-18
Proposals for Reform
System’s current status produced only
through continual tax increases
 Suggestions have been made for reform
to overcome the system’s main
weaknesses

PUBLIC SECTOR ECONOMICS: The Role of Government in the American Economy
Randall Holcombe
20-19
Insurance and Welfare
Reformers have suggested separating
insurance and welfare functions of the
system
 Insurance plan should pay benefits as a
function of earlier premiums paid
 Welfare system to pay additional benefits
based on need

PUBLIC SECTOR ECONOMICS: The Role of Government in the American Economy
Randall Holcombe
20-20
Other Reform Proposals
Raising the retirement age
 Eliminating pay-as-you-go
 Instituting mandatory private pension
plans

PUBLIC SECTOR ECONOMICS: The Role of Government in the American Economy
Randall Holcombe
20-21
Financing Program’s Deficit
from General Revenues
Federal government could provide funds
using general revenues to avoid
bankruptcy of program
 Most likely way future imbalance will be
addressed

PUBLIC SECTOR ECONOMICS: The Role of Government in the American Economy
Randall Holcombe
20-22
Cost of Imbalance in Social
Security Revenues and
Expenditures
Federal government transferring assets
among its own accounts
 Social security trust fund is an asset and
liability to federal government

PUBLIC SECTOR ECONOMICS: The Role of Government in the American Economy
Randall Holcombe
20-23