Gruber4e ch13

Public Finance and Public Policy Jonathan
CopyrightGruber
2010 Fourth
WorthEdition
Publishers
Copyright 2012 Worth Publishers
1 of 41
Social Security
13
13.1 What Is Social Security and How Does It

Work?
13.2 Consumption-Smoothing Benefits of
Social Security
13.3 Social Security and Retirement
13.4 Social Security Reform
13.5 Conclusion
P R E PAR E D B Y
Dan Sacks
Public Finance and Public Policy Jonathan Gruber Fourth Edition Copyright 2012 Worth Publishers
2 of 41
13.1
C H AP T E R 1 3 S O C I AL S E C U R I T Y
What Is Social Security and How Does It Work?
Social Security: A federal program that

taxes workers to provide income support to
the elderly.
How Is Social Security Financed?
o Through the Federal Insurance
Contributions Act (FICA) tax on their
earnings.
Who Is Eligible to Receive Social
Security?
o A person must have worked and paid
this payroll tax for 40 quarters (10 years)
over their lifetime, and must be age 62
or older.
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13.1
How Are Social Security Benefits Calculated?
Beneficiaries receive annuity payments.

o Annuity payment: A payment that
lasts until the recipients death.
Payment size depends on the recipients
average earnings over the 35 highest
earning years, called the Average Indexed
Monthly Earnings, or AIME.
Benefits are a redistributive function of past
earnings, as the replacement rate falls with
AIME.
o Replacement rate: The ratio of
benefits received to earnings prior to the
entitling event.
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13.1
Social Security Benefits as a Function of Earnings
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13.1
APPLICATION: Why Choose 35 Years?
Using the 35 highest years reflects multiple

concerns.
o No penalty for low-earning years early in
career.
o Not too large a benefit for high earning
years late in career.
Too short a window leads to abuse:
o Bus driver working 25-hour shifts to
maximize pension payment.
o Brazilian public employees receiving
promotions right before retirement.
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13.1
How Does Claiming Benefits Work?
Can claim at early entitlement age, but it

reduces benefits by 6.67% for each year
before full benefit age.
o Full Benefits Age (FBA): The age at
which a Social Security recipient receives
full retirement benefits (Primary
Insurance Amount).
o Early Entitlement Age (EEA): The
earliest age at which a Social Security
recipient can receive reduced benefits.
Delaying beyond FBA increases benefits by
8%/year, called the Delayed Retirement
Credit (DRC).
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13.1
How Does Social Security Work?
Can you work and receive Social Security?

o The earnings test reduces the benefits of
62- to 64-year-olds by $0.50 for each
dollar of earnings they have above
$13,560.
o These benefits are returned later when
the workers earnings fall below this
threshold.
Can family members receive benefits?
o Spouses of claimants, children of
deceased workers, and spouses who
survive a Social Security recipient all
receive benefits.
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13.1
Review: Social Security Terms
AIME is Average Indexed Monthly Earnings.

PIA is the Primary Insurance Amount.
FBA is the Full Benefits Age (currently age
65, rising to 67).

EEA is the Early Entitlement Age (currently
age 62).
DRC is the Delayed Retirement Credit
amount (8%).
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13.1
How Does Social Security Work Over Time?
Pension systems can be funded or unfunded.

Funded: Todays savings are invested in
various assets in order to pay future
benefits.
Unfunded: Payments collected from
todays workers go directly to todays
retirees instead of being invested in order to
pay future benefits.
Social Security is partially funded: Todays
taxes fund some but not all of future
benefits.
This leads to redistribution from young to
old.
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13.1
How Social Security Redistributes Income: Social

Security in a Two-Period World
Perio
#
d
Young
Earnin Taxe #Ol Benefi

gs
s
d
ts
100
20
2
3
4
105
110
115
21
22
23
2.1
2.2
2.3
100
105
110
2.1
2.2
2.3
Return
Infinite
10%
10%
5
121
24
0
115
0
100%
Population and earnings grow by 5% per year.
Unfunded system with 10% payroll tax.
11 of 41
13.1
Ida May Fuller
The very first beneficiary of Social Security

was Ida May Fuller.
Worked for only three years after the
establishment of the Social Security
system, and paid a total of $24.75 in Social
Security taxes:
o The first Social Security check in U.S.
history was issued to her on January 31,
1940, for $22.54.
o Ida May went on to live for 35 more
years, dying at age 100 in 1975. Over
those 35 years, she collected a total of
$22,888.92 in Social Security benefits.
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13.1
Lessons Learned
Unfunded Social Security systems

redistribute from young to old, and the first
generation are the big winners.
Unfunded systems create legacy debt.
o Legacy debt: The debt incurred by the
government because early generations
of beneficiaries received much more in
benefits than they paid in taxes.
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13.1
How Does Social Security Redistribute in Practice?
To see how Social Security redistributes in

practice, we study the Social Security
Wealth of different generations.
Social Security Wealth (SSW): The
expected present discounted value of a
persons future Social Security payments
minus the expected present discounted
value of a persons payroll tax payments.
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13.1
SSW is computed as follows:

Calculate the entire future stream of
benefits that a person expects to receive
before he or she dies.
Use a discount rate to calculate the
present discounted value (PDV) of that
stream of benefits.
Calculate the entire future stream of
taxes that a person expects to pay before
he or she dies.
Compute the PDV of that stream of taxes.
Take the difference between these two to
get the SSW.
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13.1

SSW for a Single Male
Earnings
Turns 65 Turns 65 Turns 65

in 1960
in 1995 in 2030
Low earner
$26,100
$12,500
$4,100
Average
earner
35,500
5,100
56,200
High earner
35,800
41,100 248,50
Redistribution from younger to older 0
cohorts due to:
o First cohort didnt pay in until 1937.
o Payroll tax has increased over time.
16 of 41
13.1
Some examples of how SSW varies within

groups that are the same ages include the
following:
Females have more SSW than males
because they live longer.
Married couples have more SSW than single
people.
Single-earner couples have more SSW than
two-earner couples.
The gains to the poor relative to the rich
from Social Security are overstated because
the length of life rises with income.
17 of 41
13.2
Rationales for Social Security:
One justification for Social Security is

market failure in the annuities market:
o The longer a person lives, the less
money the insurer makes from an
annuity contract.
o This could lead to such a high price for
annuities that most people would not
want to buy them.
True reason: paternalism.
o Policy makers worry that people wont
save enough.
o Most workers have very little savings
other than Social Security (and private
pensions).
18 of 41
13.2
Consumption-Smoothing Benefits of Social Security
Key question: Does Social Security smooth

consumption?
Perhaps Social Security just crowds out
savings that individuals would otherwise set
aside for their retirement.
Social Security might crowd out private
savings by allowing people to count on a
government transfer to support their
income in old age.
The larger this crowd-out is, the less
consumption smoothing Social Security
provides for retired individuals.
19 of 41
13.2
Living Standards of the Elderly, 19592009
20 of 41
13.3
EVIDENCE: Measuring the Crowd-Out Effect of

Social Security on Savings
Social Security benefits in the United States
depend on age and earnings, both of which
could be correlated with savings habits.
In Italy, reforms in 1992 cut benefits of
younger public-sector workers, relative to
older public-sector workers and privatesector workers.
Results show partial crowd-out: 3040% of
the reduction in SSW was offset by higher
private savings.
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13.3
Social Security and Retirement: Theory
What are the costs and benefits of working an

additional year at age 62?
Costs: implicit tax.
o Pay an extra year of payroll taxes on her
earnings.
o Receives one year less of Social Security
benefits.
Benefits: benefit adjustment.
o Higher Social Security benefit level
through the actuarial adjustment.
o Increase AIME.
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13.3
Elderly Work and Social Security, 19592009
23 of 41
13.3
Spike in Retirement Hazard at EEA
Retirement hazard rate: The percentage

of workers retiring at a certain age.
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13.3
Spike in Retirement Hazard at EEA
25 of 41
13.3
Retirement Hazard Rate in France
26 of 41
13.3
Evidence: Retirement Age in Germany, 19681992
Retirement age lowed from 65 to 60 in 1973.

27 of 41
13.3
APPLICATION: Implicit Social Security Taxes and

Retirement Behavior
Gruber and Wise (1999) calculated the
implicit tax from Social Security for a series
of countries.
Across countries, there is a great deal of
variation in the implicit tax rate.
o Implicit tax close to zero for 62-year-olds
in the United States.
o 91% in the Netherlands.
And countries with higher taxes have less
elderly labor force participation.
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13.3
Implicit Social Security Taxes and Retirement

Behavior
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13.3
Implications
Evidence suggests that it is potentially very

costly to design Social Security systems
that penalize additional work beyond the
retirement age.
Adjusting systems to more fairly reward
work at old ages can mitigate much of the
moral hazard effect of Social Security.
30 of 41
13.4
Social Security Reform
Social Security faces a major fiscal

imbalance as it is increasingly difficult for
young generations to pay for the benefits of
older generations.
o Rising life expectancy
o Falling birth rates
o Reduction in wage growth rates
31 of 41
13.4
Social Security Reform
32 of 41
13.4
Reform Round I: The Greenspan Commission
Commission in 1983 to improve Social

Securitys finances.
Primary recommendation:
o Social Security system should move
away from an unfunded system to some
extent.
o The government should accumulate
savings in the Social Security trust fund
so that, when the baby boomers retire,
there would be enough money to pay
their benefits.
33 of 41
13.4
APPLICATION: The Social Security Trust Fund and

National Savings
In theory, one benefit of the partial funding
of Social Security through the build-up of
the trust fund is an increase in national
savings.
The trust fund is off budget, not supposed
to be part of budget discussion.
But typically the government reports the
deficit/surplus from the unified budget,
which incorporates off-budget categories.
Makes it easy to treat trust fund as an
asset, avoid fixing the deficit.
34 of 41
13.4
Incremental Reforms
Many possible additional reforms:

Raise taxes further
Extend the base of taxable wages
Raise retirement age
Lower benefits
Reduce benefits for high income groups
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13.4
Fundamental Reforms
Fundamental reforms have also been

proposed:
Invest the trust fund in stocks
o One problem with the Greenspan
Commissions solution was that the trust
fund is very inefficiently invested.
Privatization
o A proposal to reform Social Security by
allowing individuals to invest their
payroll taxes in various assets through
individually controlled accounts.
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13.4
APPLICATION: Company Stock in 401(k) Plans
401(k) plans are an important feature of

retirement savings in the United States.
These plans allow individuals to save in selfdirected investment choices.
But there are several problems with them:
o Some workers have as much as 80% of
their assets in company stock.
o If the company fails, they will lose their
job and their savings.
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13.4
The Trade-Offs Between Fundamental Reforms
Middle ground between fundamental and

partial reform: government regulated
accounts.
o Each person would get an account
o but the government would limit
investment choices and force
annuitization.
Over the long run, an efficient retirement
portfolio should contain some stock
investments.
38 of 41
13.4
APPLICATION: Mixed Proposals for Social Security

Reform
A 2001 commission proposed three mixed
systems for partial privatization.
One plan let people invest up 2% of
wages in a personal account.
But all plans were expensive since they
diverted payroll revenue away from
current benefits, requiring other revenue
to finance.
39 of 41
13.4
APPLICATION: Mixed Proposals for Social Security

Reform
Leibman, McGuiness, and Samwicks (2005)
proposal:
Cut Social Security benefits:
o Reduce the values of the rate at which
the PIA is converted to the AIME and
raise the Full Benefits Age to 68 and the
Early Entitlement Age to 65.
Raise new revenue:
o Mandatory contributions to retirement
accounts, increase in maximum taxable
earnings.
Establish individual retirement account
with five broad options.
40 of 41
13.5
Conclusion
Social Security is the largest social

insurance program in the United States,
and the largest single expenditure item of
the federal government.
Social Security faces a long-run financing
problem to which there are no easy
solutions.
The question of how to resolve this problem
will be one of the most contentious sources
of political debate for at least the first part
of the twenty-first century.
41 of 41

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Public Finance and Public Policy Jonathan

13.1 What Is Social Security and How Does It

What Is Social Security and How Does It Work?

Social Security: A federal program that

How Are Social Security Benefits Calculated?

Beneficiaries receive annuity payments.

Social Security Benefits as a Function of Earnings

APPLICATION: Why Choose 35 Years?

Using the 35 highest years reflects multiple

How Does Claiming Benefits Work?

Can claim at early entitlement age, but it

How Does Social Security Work?

Can you work and receive Social Security?

Review: Social Security Terms

AIME is Average Indexed Monthly Earnings.

65, rising to 67).

How Does Social Security Work Over Time?

Pension systems can be funded or unfunded.

How Social Security Redistributes Income: Social

Earnin Taxe #Ol Benefi

Ida May Fuller

The very first beneficiary of Social Security

Unfunded Social Security systems

How Does Social Security Redistribute in Practice?

To see how Social Security redistributes in

How Does Social Security Redistribute in Practice?

SSW is computed as follows:

How Does Social Security Redistribute in Practice?

Turns 65 Turns 65 Turns 65

How Does Social Security Redistribute in Practice?

Some examples of how SSW varies within

Rationales for Social Security:

One justification for Social Security is

Consumption-Smoothing Benefits of Social Security

Key question: Does Social Security smooth

Living Standards of the Elderly, 19592009

EVIDENCE: Measuring the Crowd-Out Effect of

Social Security and Retirement: Theory

What are the costs and benefits of working an

Elderly Work and Social Security, 19592009

Spike in Retirement Hazard at EEA

Retirement hazard rate: The percentage

Spike in Retirement Hazard at EEA

Retirement Hazard Rate in France

Evidence: Retirement Age in Germany, 19681992

Retirement age lowed from 65 to 60 in 1973.

APPLICATION: Implicit Social Security Taxes and

Implicit Social Security Taxes and Retirement

Evidence suggests that it is potentially very

Social Security Reform

Social Security faces a major fiscal

Social Security Reform

Reform Round I: The Greenspan Commission

Commission in 1983 to improve Social

APPLICATION: The Social Security Trust Fund and

Many possible additional reforms:

Fundamental reforms have also been

APPLICATION: Company Stock in 401(k) Plans

401(k) plans are an important feature of

The Trade-Offs Between Fundamental Reforms

Middle ground between fundamental and

APPLICATION: Mixed Proposals for Social Security

APPLICATION: Mixed Proposals for Social Security