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

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

6895 Club Ridge Cir.

6895 Club Ridge Cir.

Price checked May 2010

Studios from $445

Today

We analyze another benefit that most seniors receive Social Security (SS)

Questions 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? 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

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 today’s

retirees There has been some money in reserve

Reserves projected to diminish starting in 2017

Fully Funded Plan

Period 1 Period 2 Period 3 Period 4

contribute benefits

contribute benefits

contribute benefits

The GreatestGeneration

The Baby BoomGeneration

Generation X

Work Retire Dead

Unborn

Work

Work

Retire

StillDead

DeadChildhood

Childhood Retire

Each generation’s benefits based on

deposits it made during working life plus

accumulated interest

Period 1 Period 2 Period 3 Period 4

The GreatestGeneration

The Baby BoomGeneration

Generation X

Work Retire Dead

Unborn

Work

Work

Retire

StillDead

DeadChildhood

Childhood Retire

contribute

benefits

contribute

benefits

contribute

benefits

benefits

Pay As You Go (or Unfunded) System

Each generation’s benefits come from tax

payments made by current workers

Projected revenues and payments of SS

In 2017, payments are projected to exceed tax revenue

Growth of SS in the US

Figure 11.1: Social Security expenditures (1937-2005)

0

100

200

300

400

500

600

1937 1942 1947 1952 1957 1962 1967 1972 1977 1982 1987 1992 1997 2002

Year

Rea

l Exp

end

itu

res

(200

5 $

Bill

ion

s)

0

1

2

3

4

5

6

Exp

end

itu

res

as %

of

GD

P

Real Expenditures (2006 $ Billions) Expenditures as % of GDP

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

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 gov’t decided to do so

SS tax rates over time

The Social Security Trust Fund

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

Worker RetireeTrust Fund

Retirement ageYear 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

62 is minimum retirement age (with reduction in benefits)

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

Benefit structure

0200400600800

100012001400160018002000

0 500 1000 1500 2000 2500 3000 3500 4000 4500 5000 5500

AIME

PIA

First Bend Point

Second Bend Point

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

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

Stagnation in population growth Population growth has stagnated in some

developed countries Example: Greece, 2007 estimates

Current population growth is 0.16% per year Childbearing is not keeping up with death rates

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 Source: http://en.wikipedia.org/wiki/Demographics_of_Greece

Year

Tho

usan

ds o

f pe

ople

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 has begun to retire

Statistics from Center for Disease Control and Prevention website

Graying of the population

0

1000000

2000000

3000000

4000000

5000000

6000000

1 5 9 13 17 21 25 29 33 37 41 45 49 53 57 61 65 69 73 77 81 85 89 93 97

Age

Nu

mb

er o

f p

eop

le

Series1

Series2

This graph show the number of people aged 0-99 in 1999

Baby boom generation (roughly)

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

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

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 Politically, your age group is the “next generation”

Partly solve the problem 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? 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

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

Budget constraint for present and future consumption

Present consumption (c0)

Fut

ure

cons

umpt

ion

(c1)

N

M

I0

I1

D

I0 - S

I1 + (1+r) S

S

(1+r)S

I1 - (1+r) BF

B

(1+r)B

At endowment point consumer

neither saves nor borrows

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

Utility-maximizing choice of present and future consumption

Present consumption (c0)

Fut

ure

cons

umpt

ion

(c1)

N

M

I0

I1

E1c1*

A

c0*

Saving

Crowding out of private saving due to SS

Present consumption (c0)

Fut

ure

cons

umpt

ion

(c1)

N

M

I0

I1

E1c1*

A

c0*

R

T

I0T

(1+r)T

Saving before Social Security

Saving after Social

Security

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

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

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

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

Problems

Contributions to Social Security Crowding out of private saving

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?

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

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

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

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)

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

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

Seniors in protest?

Dear Senator,I have voted for you for the last 30 years. Now that I’m

retired, you’d better not #@$*&! lower my cost-of-

living adjustment.Have a nice day,Mr. Not Working

What’s next? Attacking politicians with walkers and canes?