Chapter 8

Social Security and

Social Insurance

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Social Security Act of 1935
Requirements at that time:
 Retirement Age: 65
 Payroll Tax:
1% for employer and employee

Tax applied to the first $3000 of

earned income

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Other Nations and Social Insurance

 Germany 1889
 U.K. 1908
 France 1910

Now more than 170 nations have some

form of social security system.

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Social Security in the United States

 OASDI:
 Old Age
 Survivors
 Disability Insurance
 HI: Health Insurance (Medicare)
 UI: Unemployment Insurance

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Social Security Throughout the World

 Most systems throughout the world are similar to

the U.S. Social Security System.
 Some make fixed payments not related to pre-
retirement earnings.
 The problem of supporting more retirees with
fewer workers is greater in Japan and Western
Europe.
 Chile, Argentina, Peru, Sweden, and Mexico have
partially or fully privatized elements.

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FICA
Federal Insurance Contribution Act
 Employers and employees each currently contribute
7.65% of wages in FICA tax.

 15.3 % for the self-employed

 Taxes applied on earned income up to $87,000 in

2003 (indexed).

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 Fully Funded vs Pay-As-You-Go
 A Fully Funded  A Pay-As-You-Go
system: current fund system: current
has balances sufficient taxes pay for
to pay the present
current benefits.
value of all future
obligations.

The current U.S.system is a modified pay-as-you-

go system with a trust fund as backup.

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Social Security Trust Fund
 Since 1982, Social Security taxes collected
have greatly exceeded benefits paid out.
 The trust fund is an accounting mechanism
by which U.S. government debt is issued to
the Social Security Administration in
exchange for SS fund surpluses.
 This debt will be sold to the public when
taxes paid fall below what is needed to pay
benefits.

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 Retirement Age
 People born prior to 1935 can retire with full
benefits at 65.
 People born between 1936 and 1942 can
retire with full benefits at age 65 + 2 months
for every year after 1936 they were born.
 People born between 1943 and 1954 can
retire with full benefits at age 66.
 People born between 1955 and 1960 can
retire with full benefits at age 66 + 2 months
for every year after 1955 they were born.
 People born after 1960 can retire at full
benefits at age 67.
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 How Retirement Benefits are Computed

 The AIME (Average Index of Monthly Earnings)

calculates the highest 35 years of inflation-
adjusted earnings, expressed in monthly terms.

 The PIA (Primary Insurance Amount) is the

amount to which a individual is entitled given
their AIME.

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 Replacement Rates
 The Gross Replacement Rate is the monthly
retirement benefit divided by the monthly labor
earnings in the year prior to retirement.
 The Net Replacement Rate is the monthly after-
tax benefit divided by the monthly after-tax labor
earnings in the year prior to retirement .

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Gross Replacement Rates by Income
Worker Status Gross
Replacement Rate

Low Earner 53.6%

Average 39.9%
Earner
Maximum 24.8%
Earner
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 Figure 8.1 How Gross Replacement Rates for Social
Security Pension Recipients Vary with
Pre-retirement Earnings
110
100
Gross Replacement

90
80
Rate (Percent)

70
60
50
40
30
20
10
0
1,000 2,000 3,000 4,000
Gross Monthly Earning in the Year
Prior to Retirement (Dollars) 13
Spousal and Dependent Benefits

.5 of PIA is added for a spouse

over age 65 and for each
dependent child

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 Divorce and the Two-Income Family
 The structure of the benefit formula is such that a woman
who worked while married to a high income-earning
husband will get nothing or virtually nothing for the taxes
she paid. She and her husband would get 1.5 times his PIA
if she earned nothing and 1.5 time his PIA if she earned a
modest income.

 Divorced people are entitled to either their own PIA or half

the amount that they would have received as a couple had
they not divorced. This applies to multiple spouses as well.
Thus, breadwinners can have multiple people receiving half
or full pensions based on a single taxpayer’s earnings.

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Other Anomalies
 When one party in a marriage dies, the benefit to
the survivor depends on who made the money.
 If both earned equal amounts, then when one dies the
other receives their own amount.
 If one earned all the money and the breadwinner dies,
the survivor keeps the spouse’s pension (which is
often quite a bit more).
 Singles fair substantially worse than do married
dependent partners with deceased breadwinning
partners.

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 The Importance of Social Security
Income to the Elderly
 2/3 get more than half of their income from
Social Security.
 Private pensions only account for 20% of
elderly income.
 For low-income persons, Social Security is 80%
of their monthly income.
 More than 50% of the elderly would be below
the poverty line without Social Security.

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Cost-of-Living Adjustments
 Benefits are adjusted for inflation using
the CPI.

 Because the CPI overstates inflation

(by estimates in the neighborhood of
1.1 percentage points), Social Security
benefits increase in real terms each
year.

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How do Rates of Return Compare to
Private Pensions

 Between 1950 and 1975, the rate of return for

Social Security was around 10%.
 The predicted real rate of return will be around
2% in the future.
 Private pensions have historically yielded from 5
to 10% over a similar period of time.

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Intergenerational Transfers
 Not only does Social Security transfer
income from those who are young to those
who are old, it transfers income from the
generation born after 1945 to the generation
born before 1925. On average, those born
between 1925 and 1945 will see
approximately the same return they would
have received in a similarly safe asset.

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Demographic Changes

Birthrates have fallen such that the number

of workers supporting each retiree has fallen
from more than 30 in the 1950s to below 5
beginning in 1990. Projections show that
fewer than 3 workers will support each
retiree by 2030; shortly thereafter, fewer than
2 workers will support each retiree.

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Algebraic Look at the Result of Demographic
Changes Under a Pay-as-You-Go system
 t = (B × R)/(W × L)
Where:
 t is total benefits paid
 B is the average benefit
 R is the number of recipients
 W is taxable wages
 L is the number of workers

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Algebraic rearranging

 t = B/W × R/L = the average replacement

rate × the dependency ratio

 The dependency ratio was below .1; it is

currently above .3 and is steadily increasing,
and will be at .5 in 2030.

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Year Basic Combined Maximum Maximum Tax
OASDHI Employer- Taxable Based on
Tax Employee Tax Wages per Combined
Rate Worker Rate
Rate
1937 1.00 2.00 $3,000 $60.00

1957 2.25 4.50 $4,200 $189.00

1967 4.40 8.80 $6,600 $528.00

1977 5.85 12.10 $16,500 $1,930.50

1987 7.15 14.30 $43,800 $6,263.40

1997 7.65 15.30 $65,000 $10,006.20

2003 7.65 15.30 $87,000 $13,615.50

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Proposals to Reform Social Security
 Maintain benefits
 Increase taxability of benefits
 Invest Trust Fund in Corporate Securities
 Eventually increase payroll tax rate by 1.6 percentage
points
 Individual Accounts
 Raise retirement age
 Reduce replacement rates for upper income people
 Allow 1.6 percent of payroll to be placed in special
retirement accounts
 Personal Security Accounts
 Allow half of payroll taxes to be placed in individually
managed accounts
 Reduce guaranteed benefit

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 Impact of Social Security on Savings and
Work Incentives
Income and Substitution Effects

 The Substitution Effect leads to decreased

saving and work.

 The Income Effect may lead to an increase or

decrease in savings and work. Most
economists believe the income effect will
decrease savings and work.

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 Figure 8.2 Social Security Pensions and the
Work-Leisure Choice

A B

C
A
A
Income per Day

U2 U2
F
U1
E'
H
$30 E
G G
B $30
B
0 4 9 14 19 24 0 L1 L2 24
Leisure Hours per Day
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 Working While Eligible for Social
Security Benefits
 People may work and receive Social Security benefits.
 If they receive benefits with the reduced benefits option at
age 62, they lose $1 in benefits for every $2 they earn over
approximately $10,000.
 Those older than 65 may earn any amount and keep their
benefits.
 If they choose not to receive benefits, they receive a
greater Social Security benefit when they decide to begin
receiving them.

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 Savings Incentives of Social Security
 Asset Substitution Effect: People save less than they would if
Social Security did not exist, because they are substituting
government promises of a benefit for private savings. Stated
simply, people save less because government is “saving” for
them.
 Induced Retirement Effect: People save more than they
would if Social Security did not exist because they would not
have retired or would not have retired as early had Social
Security not been there. Given that it does exist, people
choose to ultimately retire or retire earlier and save in order to
do so.
 Bequest Effect: People save more than they would have if
Social Security did not exist in order to bequeath more to
their children and grandchildren.

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Consumption per Year after Retirement Figure 8.3 The Asset Substitution Effect

A B

A A

R E
G2 F
G U1
Social R2 E
Social F Security
Security Pension
U1
Pension U2
0 D C B 0 D C S B
S' T
S T
Consumption per Year Prior to Retirement

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The Net Effect of Social Security
on Savings

 Feldstein: Social Security leads to a

substantial reduction in savings

 Munnell: The net effect of the ASE, BE,

and IRE is nearly zero

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 Medicare
The program provides substantially subsidized health
insurance to those 65 and older. It is financed with
premiums, a 2.9% payroll tax (1.45% each for
employers and employees) and general government
revenue.
 Part A:
 Mandatory
 Covers hospitalization
 Financed with payroll tax and premiums
 Part B:
 Voluntary
 Covers doctor’s visits
 Financed from general federal revenue and premiums

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Unemployment Insurance

 Covers nearly all full-time workers

 Financed with a payroll tax on

employers up to $7000 of earnings

 Gross Replacement Rate: 33%

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