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Copyright © 2002 by Thomson Learning, Inc. Chapter 8 Social Security and Social Insurance Copyright © 2002 Thomson Learning, Inc. Thomson Learning is a trademark used herein under license. ALL RIGHTS RESERVED. Instructors of classes adopting PUBLIC FINANCE: A CONTEMPORARY APPLICATION OF THEORY TO POLICY, Seventh Edition by David N. Hyman as an assigned textbook may reproduce material from this publication for classroom use or in a secure electronic network environment that prevents downloading or reproducing the copyrighted material. Otherwise, no part of this work covered by the copyright hereon may be reproduced or used in any form or by any meansgraphic, electronic, or mechanical, including, but not limited to, photocopying, recording, taping, Web distribution, information networks, or information storage and retrieval systemswithout the written permission of the publisher. Printed in the United States of America ISBN 0-03-033652-X
Copyright © 2002 by Thomson Learning, Inc. Social Security Act of 1935 provisions of that time: Retirement Age: 65 Payroll Tax: 1% for employer and employee Tax applied to the first $3000 of earned income
Copyright © 2002 by Thomson Learning, Inc. Other Nations and Social Insurance Germany 1889 U.K. 1908 France 1910 Now more than 170 nations have some form of social security system.
Copyright © 2002 by Thomson Learning, Inc. Social Security in the United States OASDI: Old Age Survivors Disability Insurance HI: Health Insurance (Medicare) UI: Unemployment Insurance
Copyright © 2002 by Thomson Learning, Inc. FICA Federal Insurance Contribution Act Tax rate is currently 7.65% for both employers and employees 15.3 % for the self-employed Tax applied on earned income up to $76,200 in 2000 (this is indexed)
Copyright © 2002 by Thomson Learning, Inc. Fully Funded vs Pay-As-You-Go A Fully Funded system is where the current fund has balances sufficient to pay the present value of the future obligations. A Pay-As-You-Go system is where current taxes pay for current benefits. The current system is a modified pay-as- you-go system with a trust fund.
Copyright © 2002 by Thomson Learning, Inc. Social Security Trust Fund Since 1982 Social Security taxes have greatly exceeded benefits. The trust fund is an accounting mechanism by which U.S. government debt is issued to the Social Security Administration in exchange for the surpluses. This debt will be sold to the public when taxes paid fall below what is needed to pay benefits.
Copyright © 2002 by Thomson Learning, Inc. How Retirement Benefits are Computed The AIME (Average Index of Monthly Earnings) is the highest 35 years of inflation-adjusted earnings expressed in monthly terms. The PIA (Primarily Insurance Amount) is the amount to which a individual is entitled given their AIME.
Copyright © 2002 by Thomson Learning, Inc. The Gross Replacement Rate is the monthly retirement benefit over the monthly labor earnings in the year prior to retirement. The Net Replacement Rate is the monthly after-tax benefit over the monthly after-tax labor earnings in the year prior to retirement. Replacement Rates
Copyright © 2002 by Thomson Learning, Inc. Worker Status Gross Replacement Rate Low Earner52.6% Average Earner 39.1% Maximum Earner 23.7% Gross Replacement Rates by Income
Copyright © 2002 by Thomson Learning, Inc. Figure 8.1 How Gross Replacement Rates for Social Security Pension Recipients Vary with Preretirement Earnings Gross Replacement Rate (Percent) Gross Monthly Earning in the Year Prior to Retirement (Dollars) 110 100 90 80 70 60 50 40 30 20 10 0 1,0002,0003,0004,000
Copyright © 2002 by Thomson Learning, Inc. Retirement Age People born prior to 1935 can retire at full benefits at 65. People born between 1936 and 1942 can retire at full benefits at age 65 + 2 months for every year after 1936 they were born. People born between 1943 and 1954 can retire at full benefits at age 66. People born between 1955 and 1960 can retire at 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.
Copyright © 2002 by Thomson Learning, Inc. Spousal and Dependent Benefits.5 of PIA is added for a spouse and each dependent
Copyright © 2002 by Thomson Learning, Inc. 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 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.
Copyright © 2002 by Thomson Learning, Inc. 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 18% of elderly income.
Copyright © 2002 by Thomson Learning, Inc. 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), this means that there are real increases in Social Security benefits each year.
Copyright © 2002 by Thomson Learning, Inc. How do Rates of Return Compare to Private Pensions Between 1950 and 1975 the rate of return for Social Security was around 10%. It is predicted that the 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.
Copyright © 2002 by Thomson Learning, Inc. International 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 in between 1925 and 1945 will see approximately the same return they would have received in a similarly safe asset.
Copyright © 2002 by Thomson Learning, Inc. 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. It is projected to be below 3 by 2030 and below 2 shortly thereafter.
Copyright © 2002 by Thomson Learning, Inc. 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
Copyright © 2002 by Thomson Learning, Inc. 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.
Copyright © 2002 by Thomson Learning, Inc. Year Basic OASDHI Tax Rate Combined Employer- Employee Tax Rate Maximum Taxable Wages per Worker Maximum Tax Based on Combined Rate 19371.002.00$3,000$60.00 19572.254.50$4,200$189.00 19674.408.80$6,600$528.00 19775.8512.10$16,500$1,930.50 19877.1514.30$43,800$6,263.40 19977.6515.30$65,000$10,006.20 20007.6515.30$76,200$11,658.60
Copyright © 2002 by Thomson Learning, Inc. Proposals to Reform Social Security Maintain benefits Increase taxability of benefits Invested Trust Fund in Corporate Securities Eventually increase payroll tax rate by 1.6 percentage points Individual Accounts Raise the 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 the guaranteed benefit
Copyright © 2002 by Thomson Learning, Inc. 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 also decreases savings and work.
Copyright © 2002 by Thomson Learning, Inc. Figure 8.2 Social Security Pensions and the Work- Leisure Choice C A G B L1L1 L2L2 E E' 0 B $30 24 Income per Day Leisure Hours per Day 24 $30 A A G B 0491914 U2U2 F H U2U2 U1U1
Copyright © 2002 by Thomson Learning, Inc. 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 more than 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.
Copyright © 2002 by Thomson Learning, Inc. 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.
Copyright © 2002 by Thomson Learning, Inc. Figure 8.3 The Asset Substitution Effect Consumption per Year after Retirement Consumption per Year Prior to Retirement 0 A A R G B A BCD 0 G2G2 R2R2 F T S S TS' BCD Social Security Pension Social Security Pension U1U1 E U2U2 U1U1 F E
Copyright © 2002 by Thomson Learning, Inc. 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
Copyright © 2002 by Thomson Learning, Inc. 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% on employers and employees) and general government revenue. Part A: Mandatory Covers hospitalization Financed with payroll tax and premiums Part B: Voluntary Covers doctors visits Financed from general federal revenue and premium
Copyright © 2002 by Thomson Learning, Inc. 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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