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CHAPTER

20
Social Security

PUBLIC SECTOR ECONOMICS: The Role of Government in the American Economy


Randall Holcombe

Social Security
Largest

redistribution program
Established in 1935, expanded in 1956
and 1965
Paid for by earmarked payroll tax
Pay-as-you-go program
Taxes and benefits have continually risen

PUBLIC SECTOR ECONOMICS: The Role of Government in the American Economy


Randall Holcombe

20-2

Social Security Payroll Tax


Established

to function as governmentoperated retirement program


No need-based requirement to collect
transfer
Eligibility contingent on having
contributed to program in past

PUBLIC SECTOR ECONOMICS: The Role of Government in the American Economy


Randall Holcombe

20-3

Contributions
In

form of payroll tax


Income taxed at constant rate up to
specified maximum level
Employer/employee contribute equal
amounts
Increase in tax rates and maximum wage
that can be taxed
PUBLIC SECTOR ECONOMICS: The Role of Government in the American Economy
Randall Holcombe

20-4

Contributions

PUBLIC SECTOR ECONOMICS: The Role of Government in the American Economy


Randall Holcombe

20-5

Structure of the Tax


Social

security payroll tax more than 39%


of total federal taxes
Adheres to benefit principle
Criticized on regressive nature

PUBLIC SECTOR ECONOMICS: The Role of Government in the American Economy


Randall Holcombe

20-6

Burden of Payroll Tax


Tax

Shifting and Payroll Tax

Wages

set by supply and demand


Who pays tax irrelevant to after-tax income
of employee

PUBLIC SECTOR ECONOMICS: The Role of Government in the American Economy


Randall Holcombe

20-7

Visibility of Payroll Tax


Tax

levied on employer will be hidden


from employee
Easy for taxpayers to estimate their share
of cost to social security program
Double

amount shown on W-2 form

PUBLIC SECTOR ECONOMICS: The Role of Government in the American Economy


Randall Holcombe

20-8

Coverage
More

than 90% of workers in paid


employment are covered by social
security program
Eligibility
Must

have worked for 40 quarters in a


covered job
Benefits paid do not reflect present value of
past contributions
PUBLIC SECTOR ECONOMICS: The Role of Government in the American Economy
Randall Holcombe

20-9

Redistributive Nature of
Program
Reasons

social security is compulsory:


Adverse selection
Low

earners get paid more in proportion to


social security taxes than high earners
Those who do not fare well likely to bypass
system
Pay-as-you-go
Requires

solvent

system

new contributors to keep system

PUBLIC SECTOR ECONOMICS: The Role of Government in the American Economy


Randall Holcombe
20-10

Pay-As-You-Go System of
Financing
Collects

contributions from current


workers, redistributes them to current
retirees as benefits
Current contributions not invested
Dependent on new individuals entering
system
Liabilities of social security system
unfunded
PUBLIC SECTOR ECONOMICS: The Role of Government in the American Economy
Randall Holcombe

20-11

Viability of Pay-As-You-Go
More

new contributors entering system


each generation
Affected by increasing benefit payments
Affected by demographic factors:
Population

living longer

Baby

boom
People have fewer children
PUBLIC SECTOR ECONOMICS: The Role of Government in the American Economy
Randall Holcombe
20-12

Political Determination of
Benefits and Costs
Expect

rate of return on contributions to


equal growth in national income
Program subject to change through
political process
In self-interest for older generation to
vote for higher taxes in exchange for
higher benefits
PUBLIC SECTOR ECONOMICS: The Role of Government in the American Economy
Randall Holcombe
20-13

Social Security and Capital


Accumulation
Reduces

incentive for private saving


Funded Pensions
Funds

from pension substitute for private

saving
No net effect on aggregate investment
Unfunded

Pensions

Reduction

in amount of investment

PUBLIC SECTOR ECONOMICS: The Role of Government in the American Economy


Randall Holcombe
20-14

Social Security and Capital


Accumulation

PUBLIC SECTOR ECONOMICS: The Role of Government in the American Economy


Randall Holcombe
20-15

The Growth of the Social


Security Program
Original

tax was combined rate of 2


percent on income up to $3,000 annually
Today

is 15.3 percent on income up to


$84,900

In

1950, expenditures equaled 7.5


percent of assets
Today, 32.3

percent of assets

PUBLIC SECTOR ECONOMICS: The Role of Government in the American Economy


Randall Holcombe
20-16

Social Security as an
Investment
Social

security as good investment


depends on:
Structure

of future system
Future tax rates
Higher rates imply higher benefits
Growth of future income in country

PUBLIC SECTOR ECONOMICS: The Role of Government in the American Economy


Randall Holcombe
20-17

Future of Social Security


Will

pay out more in benefits than it


receives in revenues within a few
decades
Possibility of tax increases
Possibility of benefit cuts

PUBLIC SECTOR ECONOMICS: The Role of Government in the American Economy


Randall Holcombe
20-18

Proposals for Reform


Systems

current status produced only


through continual tax increases
Suggestions have been made for reform
to overcome the systems main
weaknesses

PUBLIC SECTOR ECONOMICS: The Role of Government in the American Economy


Randall Holcombe
20-19

Insurance and Welfare


Reformers

have suggested separating


insurance and welfare functions of the
system
Insurance plan should pay benefits as a
function of earlier premiums paid
Welfare system to pay additional benefits
based on need
PUBLIC SECTOR ECONOMICS: The Role of Government in the American Economy
Randall Holcombe
20-20

Other Reform Proposals


Raising

the retirement age


Eliminating pay-as-you-go
Instituting mandatory private pension
plans

PUBLIC SECTOR ECONOMICS: The Role of Government in the American Economy


Randall Holcombe
20-21

Financing Programs Deficit


from General Revenues
Federal

government could provide funds


using general revenues to avoid
bankruptcy of program
Most likely way future imbalance will be
addressed

PUBLIC SECTOR ECONOMICS: The Role of Government in the American Economy


Randall Holcombe
20-22

Cost of Imbalance in Social


Security Revenues and
Expenditures
Federal

government transferring assets


among its own accounts
Social security trust fund is an asset and
liability to federal government

PUBLIC SECTOR ECONOMICS: The Role of Government in the American Economy


Randall Holcombe
20-23

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