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CHAPTER 11

CHAPTER 11. SOCIAL SECURITY. Why Have Social Security?. Consumption Smoothing and the Annuity Market How Social Security works Annuity Consumption smoothing Adverse Selection and the Annuity Market Asymmetric information Adverse selection. Other Justifications.

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CHAPTER 11

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  1. CHAPTER 11 SOCIAL SECURITY

  2. Why Have Social Security? • Consumption Smoothing and the Annuity Market • How Social Security works • Annuity • Consumption smoothing • Adverse Selection and the Annuity Market • Asymmetric information • Adverse selection

  3. Other Justifications • Lack of foresight and paternalism • Moral hazard • Economize on decision-making and administrative costs • Income Redistribution • Improve the Economic Status of the Aged

  4. contribute contribute contribute benefits benefits benefits Fully Funded Plan The Greatest Generation Work Retire Dead StillDead Each generation’s benefits based on deposits it made during working life plus accumulated interest The Baby Boom Generation Retire Childhood Work Dead Unborn Childhood Work Retire Generation X

  5. benefits benefits benefits contribute contribute contribute 0 Pay As You Go (or Unfunded) System Work Retire Each generation’s benefits come from tax payments made by current workers Dead StillDead The Greatest Generation Childhood Work Retire Dead The Baby Boom Generation Unborn Childhood Work Retire Generation X benefits

  6. benefits benefits benefits contribute contribute contribute 0 Today’s Partially Funded System Baby Boomers and Gen X are also contributing to their own retirement Work Retire Dead StillDead The Greatest Generation Childhood Work Retire Dead The Baby Boom Generation Unborn Childhood Work Retire Generation X benefits

  7. Explicit Transfers • Benefits for dependents and survivors (1939) • Supplemental Security Income

  8. 0 Benefits • How to calculate benefits • AIME (Average Indexed Monthly Earnings) – average monthly earnings in 35 highest paid years • Wages indexed for inflation • Ceiling on AIME – up to tax ceiling

  9. 0 Benefit Structure If AIME < $656  PIA = .90*AIME If $656< AIME <$3955  PIA = .90*$656 + .32*(AIME - $656) If AIME > $3955  PIA = .90*$656 + .32*($3955-$656) + .15*(AIME - $3955) First Bend Point Second Bend Point

  10. 0 Adjustments • Annual inflation adjustment • Age at which benefit is drawn • Normal retirement age • Early retirement – benefit reduced 5/9th of one percent a month for first 36 months preceding normal retirement age • Late retirement – benefit increased 15/24th of one percent a month

  11. Adjustments • Family Status • +50% for spouse or dependent child • If covered worker dies spouse receives 100% of worker’s benefit or spouse’s benefit • Divorced spouse married at least 10 years gets spouse benefit if not remarried while covered worker alive • Earnings test and taxing benefits • Benefits reduced $1 for every $2 earned above $12,480 • Individuals losing benefits may have later benefits increased • Up to 85% of benefits taxed for recipients with income above a base amount ($25,000 for single and $32,000 for married taxpayers.)

  12. 0 Financing • FICA (Federal Insurance Contribution Act) • 2006 Social Security Tax rates • Employee • 6.2% (OASI - 5.6%, DI - .6%) of first $94,200 of earnings on both employee and employer • Self-employed • 12.4% • 2006 Medicare Tax rates • 1.45% on both employer and employee with no earnings ceiling • Why not fund Social Security through general tax revenues?

  13. Distributional Issues • Actuarially fair return • Intergenerational redistribution • Total benefits = Nb * B • Total taxes = t * Nw * w • If total benefits = total taxes:Nb * B = t * Nw * w orB = t * (Nw/Nb) * w • Ida Mae Fuller

  14. Social Security Wealth for Representative Individuals

  15. Other Distributional Issues • Redistribution within a generation • Differences by earnings • Differences by lifespan • Differences by living arrangements • Differences by number of earners in the family • Normative evaluation

  16. Trust Fund Worker Retiree 0 The Social Security Trust Fund • Social Security and National Saving • Budget Treatment of Social Security • Off budget • Unified budget

  17. Social Security and Savings Behavior • Life-cycle theory of savings • Wealth Substitution Effect • Retirement Effect • Bequest Effect

  18. Empirical Evidence • Martin Feldstein’s work • CONS = f(DI, W, SSW, X) • MPCssw = .028 • 60% reduction in personal saving • Others • Rosen: Social security has had a negative effect on saving, but magnitude of effect is unclear

  19. 0 Effects on Retirement and Labor Supply • 1930 LFPR 65+ was 54% • 2001 LFPR 65+ was 18% • Effect of Social Security • Income Effect – SS raises retirement income • Substitution Effect – SS reduces the cost of retiring • Earnings test • Impact on Younger Workers?

  20. Distribution of Wealth • Bequeathable v Annuitized Wealth • Effect of Social Security on Bequeathable Wealth • Effect on Wealth Mobility

  21. Budget Constraint for Present and Future Consumption N D At endowment point consumer neither saves nor borrows Future consumption (c1) (1+r)S I1 + (1+r) S B I1 (1+r)B F S I1 - (1+r) B M I0 - S I0 Present consumption (c0)

  22. Utility-maximizing Choice of Present and Future Consumption N Future consumption (c1) E1 c1* A I1 Saving M c0* I0 Present consumption (c0)

  23. Crowding out of private saving due to Social Security N Future consumption (c1) E1 c1* R A I1 (1+r)T Saving before Social Security T Saving after Social Security M c0* I0 I0T Present consumption (c0)

  24. Other ways Social Security Affects Saving • Retirement effect • Bequest effect • Empirical evidence

  25. Retirement Decisions • Social security wealth and the retirement decision • Empirical evidence • Diamond and Gruber [199] • Gruber and Wise [2004]

  26. Long-Term Stresses on Social Security Source: Social Security Trustees [2006]

  27. Long-Term Stresses on Social Security Since:B = t * (Nw/Nb) * w Rearrange: t = (Nw/Nb)* (B/w) Dependency Ratio Replacement Ratio

  28. Social Security Reform • Time horizon for solvency • Sustainable solvency

  29. Maintain the Current System • Raise the payroll tax • Raise the Maximum Taxable Earnings Level • Raise the Retirement Age • Reducing the Cost-of-Living Adjustment • Change the Benefit Formula • Comparing the Options

  30. Privatize the System • Personal Accounts • Pros and cons of personal accounts • Effect on Solvency • Effect on Saving • Carve-out accounts • Add-on accounts • Risk • Administration • Distribution

  31. Policy Perspective: President Bush’s Social Security Reform Proposal • Voluntary personal accounts • Carve-outs • Government management • Portfolio limitations • Benefit offsets • Inheritability • Achieving sustainable solvency • Progressive indexing

  32. Empirical Evidence: Does Social Security Reduce Saving? • Time-series evidence • Martin Feldstein (1974, 1996) v Leimer and Lesnoy (1982) • Cross-section evidence • Evidence from other countries • Attanasio and Brugiavini (2003) and Italy

  33. 0 Ida Mae Fuller

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