Removing the Disincentives in Social Security for Long Careers

Removing the Disincentives in Social Security for Long Careers October 20, 2006 Gopi Shah Goda, Stanford University John Shoven, Ph.D., Stanford University Sita Slavov, Ph.D., Occidental College

Motivation • Life expectancy has improved dramatically since the introduction of Social Security • Period life expectancy for 20-year-olds in 1935 was 66 for males, 69 for females • Today, 20-year-old males have life expectancy of 76, and females have life expectancy of 80 • However, men are retiring much earlier

What are implicit Social Security tax rates? • The implicit Social Security tax rate for an individual age x is defined as the additional taxes paid at age x, less the present value of additional Social Security benefits accrued, divided by earnings at age x

Social Security Benefit Calculation Pay CPI-Indexed PIA from Retirement Age until Death Earnings History Calculate PIA (Primary Insurance Amount) Cap & Wage Index Earnings Choose Highest 35 Years slope = 0.15 slope = 0.32 Calculate AIME (Average Indexed Monthly Earnings) slope = 0.90

Assumptions • Single male worker who starts working at age 20, and retires at the NRA • Assume 2005 benefit rules persist • Earnings by age simulated using a time-series of average wages for U.S. and an age-wage profile constructed from 2001 and 2002 CPS • OASI tax rate = 10.6%  maximum implicit tax • Real wage growth = 1% • Real discount rate = 2% • Work years are “front-ended”

0.1 0.05 Implicit Tax Rate 0 average 10th %ile 90th %ile full cap -0.05 -0.1 15 20 25 30 35 40 45 Career Length

Male Mortality 0.1 0.05 0 Implicit Tax Rate average 10th %ile 90th %ile full cap -0.05 -0.1 15 20 25 30 35 40 45 Career Length

Female Mortality 0.1 0.05 0 Implicit Tax Rate average 10th %ile 90th %ile full cap -0.05 -0.1 15 20 25 30 35 40 45 Career Length

Why do we see these patterns? • Once a person works 35 years, additional years of earnings are no longer replacing zeroes – they are replacing lower earnings years • Each additional year of work does not count the same because of the way the system handles progressivity

What do implicit tax rates look like for actual earnings histories? • Benefits and Earnings Public Use File, 2004 • 1% sample of SSA beneficiaries in December 2004 • Limit attention to beneficiaries receiving retirement benefits based on their own earnings histories, and who started working 1951 or later • This leaves 123,552 individuals in the sample • 75,368 men and 48,184 women • Birth years range from 1910 to 1942 • Earnings above the cap are not available • No way to link couples in the data

Three Possible Reforms • Use 40 years rather than 35 in the AIME calculation • Disentangle career length and progressivity Current PIA Calculation Proposed PIA Calculation

Three Possible Reforms • Use 40 years rather than 35 in the AIME calculation • Disentangle career length and progressivity • Establish a “paid-up” category of workers who have worked a full career of 40 years

average 0.1 10th %ile 90th %ile full cap 0.05 Implicit Tax Rate 0 -0.05 -0.1 15 20 25 30 35 40 45 Career Length

What impact do these reforms have on progressivity?

What impact do these reforms have on women? • Since women in the sample are more likely to experience shorter careers, the reforms disproportionately affect women • Benefit levels are 2.44% higher for males, 0.07% higher for females (vs. 1.52% overall) • We look at policies to alleviate this redistribution…

What impact do these reforms have on women?

Summary • Flat payroll taxes and the current benefit formula together imply that workers face increasing disincentives for working long careers • This may be contributing to what could be suboptimally long retirement periods

Summary • Policies that flatten the pattern of implicit taxes as individuals age would reduce the disincentives of working longer careers • These policies can be enacted in ways that are either revenue- or benefit-neutral in aggregate • These policies would involve some redistribution from individuals who work short careers to individuals who work long careers

Removing the Disincentives in Social Security for Long Careers