Public Finance ( MPA405 )

1. Public Finance (MPA405) Dr. Khurrum S. Mughal

2. Lecture 19: Social Security and Social Insurance Public Finance

3. Pay-as-you-go Pension System • In an unfunded defined benefit pension • no assets are set aside and the benefits are paid for by the employer or other pension sponsor as and when they are paid. • Pension arrangements provided by the state in most countries in the world are unfunded, with benefits paid directly from current workers' contributions and taxes.

4. Pay-as-you-go Pension System • Economic Theory • Distorts saving and work choices • No conclusive evidence confirms this • Combined effect of influence on choices of • Those who pay taxes to finance • Those already receiving or close to receiving • Our analysis is for those who are eligible

5. Impact of Social Security on Savings and Work IncentivesIncome 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 also decreases savings and work. • We discuss the impact of pension and earnings test on worker’s work incentive

6. U2 F H Social Security Pensions and the Work-Leisure Choice A • Worker not of full retirement age, subject to earnings test • Subsidy shifts Budget Line up with $30 and decreases its slope with more leisure • Point H: $6 per hr, 5 hrs per day, 19 hrs of leisure • 15 Hrs per day, $90 per day, 9 hrs for leisure and pension reduced to zero. • $60 more than wage subject to earnings test • Pension = 30-60/2=0 • Income effect – some earnings without work • Work increases work income but reduces transfer income • An incentive to substitute A Income per Day $30 G B 0 4 9 14 19 24 Leisure Hours per Day

7. U2 U1 Social Security Pensions and the Work-Leisure Choice B • Retiree older than the normal retirement age • Not subject to earnings test • Equilibrium at point E before retirement • At E` after retirement • Only income effect C A Income per Day E' E G $30 B 0 L1 L2 24 Leisure Hours per Day

8. 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 give more to the children and grandchildren when they die.

9. E U1 F Social Security Pension S' T S The Asset Substitution Effect A • Saving CB for future use in absence of Govt Program • Tax T and promised future consumption G • T less than S, the amount worker would otherwise save annually • Lesser resources at hand to save • AFD – trade current consumption for future • Still saves CD • Asset Substitution effect • Reduction in saving A R Consumption per Year after Retirement G 0 C D B Consumption per Year Prior to Retirement

10. The Asset Substitution Effect F E Social Security Pension U1 U2 S T • At U2- Saving CB for future use in absence of Govt Program - R2 • Tax T and promised future consumption G2 • T less than S, the amount worker would otherwise save annually • Point F on U1 • AFD – trade current consumption for future • Savings fall to zero • Pension plan too generous for her preferences • Excess burden - U1 < U2 B A Consumption per Year after Retirement G2 R2 D C B 0 Consumption per Year Prior to Retirement

11. Savings Incentives of Social Security • 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 give more to the children and grandchildren when they die.

12. The Net Effect of Social Security on Savings • Martin Feldstein: Social Security leads to a substantial reduction in savings – Asset Substitution Effect • Alicia Munnell: The net effect of the Asset Substitution Effect and Induced Retirement Effect is nearly zero

13. Government and Health Care Public Finance

14. Why Health Care is Different • Uncertainty: • People do not typically know what their health care expenses will be.  • Insurance: • Because of uncertainty people typically buy health insurance. • This means that people do not typically pay the full marginal cost of their health expenses.

15. Health Insurance and the Market for Health Care Marginal Social Cost Supply = Loss in Net Benefits Marginal Social Benefit Demand = P2 A C P * Price (Dollars per Unit Service) B P1 Q* Q1 Health Care Services per Year

16. Implications • Patients: • After deductibles, patients only pay a fraction of expenses on surgery, stay, and drugs. • People visit for minor ailments • Their demand increases • Hospitals: • To meet the demand they hire more resources. • People only pay a fraction so they prescribe more tests and other services than they normally would do. • Amount paid by 3rd parties area P1P2AB