Chapter 13: Social Security

Public Economics Dr. Sauer

Over the next 75 years, Social Security has promised $5.6 trillion more in benefits than it plans to collect from worker taxes. Reforming Social Security is difficult because it is the largest source of income for the elderly. 60% of beneficiaries derive more than half their income from it 30% of beneficiaries derive 90% of their income from it Financing: 6.2% from employee 6.2% from employer only on first $106,800 of income Benefits: age 62, age 65 worked and paid in during 40 quarters annuity Full retirement age benefit = primary insurance amount (PIA). formula based on your earnings history: - adjust for inflation - 35 top years - average monthly earnings Step 1: Calculate Taxed Social Security Earnings Find your taxed SS earnings for every year in your work history. - earnings up to the SS threshold ($106,800) - start the year after you turn 21 - statements come to you starting at 25 Earnings are wages from employment and net earnings from self-employment. - not investment income

Step 2: Adjust for Inflation Adjust the earnings for earlier years to reflect inflation. - table - changes every year The indexing year is normally the year you turn 60. If you die or become disabled before age 62, the indexing year will be two years before the year of your death or disability. Step 3: Select the 35 Highest Years Select the 35 highest years based on the inflation-adjusted amounts. If you don't have 35 years with earnings, the calculation will include some years with zero earnings. Step 4: Find the Monthly Average Add up all the inflation-adjusted amounts for the 35 years that were selected and divide by 420. This is known as your average indexed monthly earnings (AIME). The calculation uses a smaller number of years for someone who dies or becomes disabled before age 62. Step 5: The Benefits Formula 3-tier formula: An AIME of less than $749 means $0.90 in benefits for each $1 of AIME $749 to $4,517 means $0.32 in benefits for each $1 of AIME over $4,517 means $0.15 in benefits for each $1 of AIME

http://www.socialsecurity.gov/OACT/COLA/piaformula.html How SS works: simple model People live for two periods - young work - old retired Population growth is 5% per year. Productivity growth is 5% per year. Consider 5 total periods. 2

Period 1: - 100 young people work, earn $20,000 in period - no social security (no retirees) Period 2: - 100 retirees - social security program implemented - 10% tax on workers - paid immediately to retirees - 105 workers, earn taxed - total tax collected - total payments per retiree - return on investment
Taxes Previously paid by retiree

Period 1 2 3 4 5

# Workers

Earnings per worker

Taxes per worker

Total Taxes

# Retirees

Benefits per retiree

Rate of Return

Period 3: - 105 retirees - 105 x 1.05 = 110.25 = 110 workers - workers earn - workers pay - total taxes - benefit per retiree - return on investment Repeat for Period 4 In Period 5, workers do not pay in (there will be no period 6 where they will get benefits). The generation working in period 4 does not receive benefits. For unfunded social security programs, - initial generation benefits hugely - middle generations benefits depend on the growth of population and productivity 3

- final generation is harmed Redistribution in Practice Redistribution is measured by comparing the Social Security Wealth (SSW) accruing to different generations. SSW = expected PDV of future lifetime SS benefits - expected PDV of lifetime payroll taxes Use expected value because death date is uncertain. SSW for unmarried males turning 65 in various years

Females have larger SSW than males. - pay same taxes - live longer so receive more benefits Married couples have larger SSW than single people. - spouses of workers are entitled to 50% of workers benefits - surviving spouses receive 100% of workers benefits Single-earner couples have larger SSW than dual-income couples. - full benefits for worker, paid in - half benefits for non-worker, not paid in

Figure 13-2: Elderly Poverty and Social Security

Social Security and Retirement Two Theoretical Effects of SS on Retirement Decisions: 1. redistribution - some groups become richer, some poorer - groups that become richer will buy more retirement 2. implicit taxation - reduce the value of SS benefits if retirement is delayed ex: work until 63 instead of 62 - pay an extra year of payroll taxes - receive one year less of SS benefits - get higher SS benefit level due to actuarial adjustment - get to replace a lower earnings year Ultimate effect depends on if the first two factors dominate the second two.

Evidence: 1. time series Labor Force Participation Figure 13-3: LFP and Social Security

2. age pattern of retirement 5

The retirement hazard rate is the % of workers retiring at a certain age. Figure 13-4: Retirement Hazard

Maybe there are other reasons people choose to retire at 62 and 65? Check the retirement hazard rate before the Early Entitlement Age of 62 was implemented. Figure 13-5: Hazard Rate, Various years

3. international comparisons Figure 13-6: Hazard Rate in France

Figure 13-7: Mean Retirement Age, Germany - 1973 lowered age from 65 to 60

Social Securitys Fiscal Imbalance Figure 13-9: Ratio of Elderly to Working Age

3 Factors: 1. increase in life-expectancy 2. reduction in birth rates 3. legacy debt (unfunded payments to first generations)

The deficit figure that gets reported in the news is Revenues Outlays = deficit Since Social Security runs a surplus, the government borrows money from it. (the Postal Service runs deficits) Revenues are really less: The deficit is really more: Weve borrowed a lot of money from Social Security! Reform Incremental Reforms - raise payroll taxes - 1.7 percentage points would get us 75 years - 3.2 percentage points would get us forever - extend the base of taxable wages - raise retirement age - lower benefits - reduce benefits for high income 8