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Social Security

Contemporary Problems in EconomicsS. Cunningham

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Origins 1935: Great Depression, FDR Social Security Act

Created a “system of federal old-age benefits” (defined benefits program)

1956, added disability benefits Two parts:

“Old age and survivors’ program” “Disability program” “Supplemental security income program” for the aged,

blind, and disabled (without regard to prior workforce participation, or “pay-in”)—Administered by SSA, but not funded by SS taxes.

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FICA and Medicare FICA: Federal Insurance Contributions Act Medicare: Medical Benefits for the Elderly

SS MedicareFICA (Total)

Employee Tax 6.2% 1.45% 7.65%

Employer Tax 6.2% 1.45% 7.65%

Total 12.4% 2.9% 15.3%

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FICA and Medicare (2) Threshold: Any income earned above the threshold is

not taxed 2005 -- $90,000 2000 -- $75,200 1935 -- $3,000

SS Act of 1935, the tax rate was 2% 1950 – 3% 1960 – 6% 1970 – 8.4% 1980 – 10.2% 1990 – 12.4% 2000 – 12.4%

SS Taxes have been raised 20 times since 1937.

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Entitlement? Daniel Shapiro, Making Sense of Social

Security Reform. Perceived intergenerational character of SS.

Each generation supports the generation before• Feel entitled• Operates like a large family

But FICA collects a surplus now, and later will run a deficit.

• Is this a simple intergenerational transfer?• This is not really pay-as-you-go

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Redistribution If some receive more than they pay, then there

is a distributional effect—you may gain or lose. Incentives change Is this forced saving? Can the government save?

Saving is forgoing current consumption in order to finance future consumption. Is there actually saving in this system, a deferral of

consumption? There may be individual saving, but is there net saving?

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Incentive effects SS transfers wealth from some workers to

others—it is redistributional It is a net wage tax to those who lose from it. It is a net wage subsidy to those who gain

from it. It affects work decisions

The SS tax reduces the immediate return to work

Affects spouse’s decision Depends mostly on perceptions—has saving

fallen because of SS?

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Social Insurance? Insurance depends on statistical

analysis of risk Individual outcomes are unpredictable,

but large numbers of people will have outcomes that are statistically predictable.

Pooling to protect against nonsystematic risk

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Private Insurance Problems to privately provided insurance:

Insured losses must be measurable and verifiable.

People must enter into the insurance contract before the insured event occurs.

Must mitigate against adverse selection. Must mitigate against moral hazard. The cost of insurance must not be higher than

people are willing to pay.

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Public Insurance The rationale for gov’t provision of insurance must be that

it can resolve some of these problems that private firms cannot. More complete pools. (Avoids adverse selection) Better information. Gov’t can force people to prepare for their retirement when

they won’t do it for themselves. (Issue of price.) Gov’t can prevent risk:

• Auto safety• Drinking and driving• Outlaw smoking• Laws against fatty foods? (Food and drug policy)• Gov’t can force risk-reducing behavior.

Each participant pays a premium that need not be equal to the expected value of the benefits.

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Risk? Perhaps SS is not insurance because

there is no risk to insure against. Is it simple redistribution? Is it insurance against income loss?

Age is important factor: Old are more risk-averse Less able to make up for losses Use age instead of health because it is more

objective and less open to question

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Plan Types Defined Contribution Plans

Specifies what the payer must contribute

Defined Benefit Plans Worker’s ultimate retirement benefit is

specified in advance. SS tries to be both, but is clearly the

second—benefits are considered guaranteed.

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Guarantees? According to a 1960 Supreme Court

ruling, Americans have no ownership rights to the money they pay into Social Security.

The federal government has no contractual obligation of any kind.

The benefits you receive may be changed at any time by Congress.

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Guarantees? According to the Social Security

Administration’s website, “There has been a temptation throughout the

program’s history for some people to suppose that their FICA payroll taxes entitle them to a benefit in a legal, contractual sense… Congress clearly had no such limitation in mind when crafting the law.”

“Benefits which are granted at one time can be withdrawn…”

Money that people pay in Social Security taxes is not saved for them and is not their property.

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Pay As You Go? Workers currently pay more in SS taxes than is

being paid out. The surplus is used to finance the federal debt.

By 2017, by some estimates, the system will run a deficit.

Problem: in 1950, there were 16 workers/payers for every retiree

on SS. Today there are 3.4 for each retiree. In 2030, there will be 2.1 for each retiree. (This will

require a tax rate of 18%+.

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Is the Trust Fund a Fraud? What happens when the SS draws on its

Trust Fund? Surpluses have been held in treasury

debt. How will the funds be “retrieved” when needed? Pay back SS from taxes? (raise taxes?) Sell more debt to pay off earlier debt? (roll-

over, possibly raising interest rates) Is this just a hoax perpetrated on the U.S.

public?

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Nature of the Trust Fund According to the FY2000 Budget prepared

by the Clinton Administration: “These Trust Fund balances … do not consist

of real economic assets than can be drawn down in the future to fund benefits. Instead, they are claims on the Treasury that, when redeemed, will have to be financed by raising taxes, borrowing from the public, or reducing benefits or other expenditures. The existence of Trust Fund balances, therefore, does not by itself have any impact on the government’s ability to pay benefits.”

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Social Security as a Tax In 1936: “… beginning in 1949… you and your

employer will each pay 3 cents on each dollar you earn, up to $3000 a year. That is the most you will ever pay.”

After adjusting for inflation, this would be $1620 today. The actual maximum collected is more than 5 times this amount!

In 2000, SS taxes accounted for 25% of all federal tax collections.

The average worker pays an amount equal to 6 weeks worth of their salary in SS taxes each year.

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Benefits To qualify for old age benefits, a person

must work 40 quarters (10 years), earning at least $3,120 a year.

The actual benefits are based upon a formula that takes into account the taxes paid by the worker.

The formula penalizes workers for making more money or worker more years.

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Benefits (2)

Benefits are increased once a year based on cost of living.

Receive full benefits at “full retirement age”, which is 65-67 depending on your year of birth.

Can opt to retire with less at 62, or more later.

Average Annual Income Avg Annual Taxes Old Age Benefit

$20,440 $2,535 $9,200

$40,880 $5,069 $14,800

$74,197 $9,200 $17,424

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Benefits (3) If a married worker dies, their spouse receives

50-67% of the couples’ combined benefits. Additional benefits to families with minor or disabled.

Note that about 1/3 of Americans have no savings, and about 1/3 have less than $2,500 in savings.

To qualify for disability benefits, a person must work for 5 years, and have been disabled for 5 months.

Disability benefits are higher than retirement benefits.

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Distribution of Benefits

Retired Workers & Their Families 67.4%

Survivors of Deceased Workers 19.8%

Disabled Workers & Their Families 12.8%

Data is from 1999.

As of June 2000, 45.2 million people were receiving Social Security benefits.

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Causes of the problem Increase in life expectancy without

comparable increase in retirement age.

Higher birth rate of baby boom generation compared with later generations.

Increasing number of people receiving disability benefits.

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Life Expectancy When SS started paying benefits in

1940, the average 65 year old male had a life expectancy of 11.9 years. As of 2000, the average 65 year old

male has a life expectancy of 15.9%--an increase of 34%.

Women at 65 lived 13,4 more years, now 19.2 more years—an increase of 43%.

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Birth Rates In the late 1940s until the early 1960s, the

average birth rate per woman was 3.7. By 1976, the average birth rate had fallen to 1.7. In 2000, it was 2.1.

Around 2010, the baby boom generation will begin to retire. Between 2010-2030, the number of people eligible for

old age benefits will increase by about 80%. The number paying SS taxes will increase by 2%.

1960-2000, U.S. population grew by 56%. Number receiving disability benefits grew by 876%.

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Disability Benefits

Between 1960 and 2000, the population grew by 56%. The number of people receiving disability benefits grew by 876%.

Year Population Number on Disability Benefits

1960 180,000,000 687,000

2000 281,000,000 6,709,000

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Trust Fund By law, SS surpluses must be invested in federal

securities. That is, the only thing the SS program can do with its surplus money is to loan it to the federal government to be spent elsewhere.

The federal gov’t is required to pay this money back to SS as necessary, with interest.

Between 2015 and 2017, the annual shortfalls of SS will require the federal government to begin paying back the money.

By 2037 (some estimates), the money and interest the federal gov’t owes to SS will be paid in full.

Between 2037 and 2075, SS will run annual deficits totaling $30 trillion.

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SS and Federal Debt Two kinds of debt:

Intragovernmental holdings or nonmarketable debt—owed to federal entities.

Debt held by the Public or Marketable Debt—owed to non-federal entities. This is “net debt”.

Owed to Federal Entities $2.7 trillion

Owed to Non-Federal Entities $3.0 trillion

Total Debt $5.7 trillion

December 31, 2000

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SS & Debt (2) If Congress uses SS surpluses to pay off debt it owes to

non-federal entities, this is called “Putting Social Security into a lockbox.”

If Congress uses money from SS surplus to fund government programs, this is called “Raiding the Social Security Trust Fund.”

When the gov’t does either, the finances of the Social Security program are not affected.

There have been bills proposed to outlaw “raiding the fund.” None have passed.

During the Clinton Administration, when many reported that the budget was “balanced,” it did not account for the interest owed on the debt to federal entities. The national debt has risen every year since 1960.

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Privatization George W. Bush has proposed to give individuals the

option to place 16% of their Social Security taxes into a private account, turning it into a “forced saving program.”

People who do this could put their money into bank accounts or lower-risk investments.

This proposal would have a negative effect on the short-term finances of the SS system because its receipts would fall.

Longer term, it would have a positive effect on the system because the SS would pay less in benefits.

People could pass on their SS savings to their heirs.

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SS Trustees Report To cover Social Security’s total cash shortfalls in perpetuity

would demand a lump-sum payment today of $11.9 trillion. To achieve permanent solvency under traditional SS financing

would demand an immediate tax increase equal to 4.47% of payroll. This amounts to raising the SS part of FICA from 12.4% to 16.87%. Including revenue derived from income taxes on benefits, this becomes 18.93%. (Add Medicare tax to this: 18.93% + 2.9% = 21.83%)

By contrast, a number of personal account plans certified by SS actuaries achieve sustained solvency without large tax increases.

The 2003 report includes a “stochastic analysis” that accounts for the infinite variability of the economic and demographic factors affecting SS finances.