Holcombe 20

20CHAPTER

Social Security

PUBLIC SECTOR ECONOMICS: The Role of Government in the American EconomyRandall Holcombe

PUBLIC SECTOR ECONOMICS: The Role of Government in the American EconomyRandall Holcombe 20-2

Social SecuritySocial Security

Largest redistribution programLargest redistribution program Established in 1935, expanded in Established in 1935, expanded in

1956 and 19651956 and 1965 Paid for by earmarked payroll taxPaid for by earmarked payroll tax Pay-as-you-go programPay-as-you-go program Taxes and benefits have continually Taxes and benefits have continually

risenrisen


Social Security Payroll Social Security Payroll TaxTax

Established to function as Established to function as government-operated retirement government-operated retirement programprogram

No need-based requirement to No need-based requirement to collect transfercollect transfer

Eligibility contingent on having Eligibility contingent on having contributed to program in pastcontributed to program in past


ContributionsContributions

In form of payroll taxIn form of payroll tax Income taxed at constant rate up to Income taxed at constant rate up to

specified maximum levelspecified maximum level Employer/employee contribute equal Employer/employee contribute equal

amountsamounts Increase in tax rates and maximum Increase in tax rates and maximum

wage that can be taxedwage that can be taxed


ContributionsContributions

YearCombined Employer and Employee Tax

Rates

Maximum Taxable Income

Social Security as a Percentage of Total Federal Expenditures

1940 2.00% $3,000 0.6%

1950 3.00% $3,000 2.5%

1960 6.00% $4,800 12.6%

1970 8.40% $7,800 15.5%

1980 12.26% $25,900 20.0%

1990 15.30% $51,300 19.8%

2000 15.30% $76,200 22.9%

2004 15.30% $87,900 22.4%

Source: Statistical Abstract of the United States , various issues.

Table 20.1 Characteristics of the Social Security Program for Selected Years

Note: Tax rates are for Social Security and Medicare. Beginning in 1994 all income above the Social Security maximum taxable income is taxed 2.9 percent for Medicare.


Structure of the TaxStructure of the Tax

Social security payroll tax more than Social security payroll tax more than 39% of total federal taxes39% of total federal taxes

Adheres to benefit principleAdheres to benefit principle Criticized on regressive natureCriticized on regressive nature


Burden of Payroll TaxBurden of Payroll Tax

Tax Shifting and Payroll TaxTax Shifting and Payroll Tax Wages set by supply and demandWages set by supply and demand Who pays tax irrelevant to after-tax Who pays tax irrelevant to after-tax

income of employeeincome of employee


Visibility of Payroll TaxVisibility of Payroll Tax

Tax levied on employer will be Tax levied on employer will be hidden from employeehidden from employee

Easy for taxpayers to estimate their Easy for taxpayers to estimate their share of cost to social security share of cost to social security programprogram Double amount shown on W-2 formDouble amount shown on W-2 form


CoverageCoverage

More than 90% of workers in paid More than 90% of workers in paid employment are covered by social employment are covered by social security programsecurity program

EligibilityEligibility Must have worked for 40 quarters in a Must have worked for 40 quarters in a

covered jobcovered job Benefits paid do not reflect present Benefits paid do not reflect present

value of past contributionsvalue of past contributions


Redistributive Nature of Redistributive Nature of ProgramProgram

Reasons social security is compulsory:Reasons social security is compulsory: Adverse selectionAdverse selection

Low earners get paid more in proportion to Low earners get paid more in proportion to social security taxes than high earnerssocial security taxes than high earners

Those who do not fare well likely to bypass Those who do not fare well likely to bypass systemsystem

Pay-as-you-go systemPay-as-you-go system Requires new contributors to keep system Requires new contributors to keep system

solventsolvent


Pay-As-You-Go System of Pay-As-You-Go System of FinancingFinancing

Collects contributions from current Collects contributions from current workers, redistributes them to workers, redistributes them to current retirees as benefitscurrent retirees as benefits

Current contributions not investedCurrent contributions not invested Dependent on new individuals Dependent on new individuals

entering systementering system Liabilities of social security system Liabilities of social security system

unfundedunfunded


Viability of Pay-As-You-Viability of Pay-As-You-GoGo

More new contributors entering More new contributors entering system each generationsystem each generation

Affected by increasing benefit Affected by increasing benefit paymentspayments

Affected by demographic factors:Affected by demographic factors: Population living longerPopulation living longer Baby boomBaby boom People have fewer childrenPeople have fewer children


Political Determination Political Determination of Benefits and Costsof Benefits and Costs

Expect rate of return on contributions Expect rate of return on contributions to equal growth in national incometo equal growth in national income

Program subject to change through Program subject to change through political processpolitical process

In self-interest for older generation to In self-interest for older generation to vote for higher taxes in exchange for vote for higher taxes in exchange for higher benefitshigher benefits


Social Security and Social Security and Capital AccumulationCapital Accumulation

Reduces incentive for private savingReduces incentive for private saving Funded PensionsFunded Pensions

Funds from pension substitute for Funds from pension substitute for private savingprivate saving

No net effect on aggregate investmentNo net effect on aggregate investment Unfunded PensionsUnfunded Pensions

Reduction in amount of investmentReduction in amount of investment


Social Security and Social Security and Capital AccumulationCapital Accumulation


The Growth of the Social The Growth of the Social Security ProgramSecurity Program

Original tax was combined rate of 2 Original tax was combined rate of 2 percent on income up to $3,000 percent on income up to $3,000 annuallyannually Today is 15.3 percent on income up to Today is 15.3 percent on income up to

$84,900$84,900 In 1950, expenditures equaled 7.5 In 1950, expenditures equaled 7.5

percent of assetspercent of assets Today, 32.3 percent of assetsToday, 32.3 percent of assets


Social Security as an Social Security as an InvestmentInvestment

Social security as good investment Social security as good investment depends on:depends on: Structure of future systemStructure of future system Future tax ratesFuture tax rates Higher rates imply higher benefitsHigher rates imply higher benefits Growth of future income in countryGrowth of future income in country


Future of Social SecurityFuture of Social Security

Will pay out more in benefits than it Will pay out more in benefits than it receives in revenues within a few receives in revenues within a few decadesdecades

Possibility of tax increasesPossibility of tax increases Possibility of benefit cutsPossibility of benefit cuts


Proposals for ReformProposals for Reform

System’s current status produced System’s current status produced only through continual tax increasesonly through continual tax increases

Suggestions have been made for Suggestions have been made for reform to overcome the system’s reform to overcome the system’s main weaknessesmain weaknesses


Insurance and WelfareInsurance and Welfare

Reformers have suggested Reformers have suggested separating insurance and welfare separating insurance and welfare functions of the systemfunctions of the system

Insurance plan should pay benefits Insurance plan should pay benefits as a function of earlier premiums as a function of earlier premiums paidpaid

Welfare system to pay additional Welfare system to pay additional benefits based on needbenefits based on need


Other Reform ProposalsOther Reform Proposals

Raising the retirement ageRaising the retirement age Eliminating pay-as-you-goEliminating pay-as-you-go Instituting mandatory private Instituting mandatory private

pension planspension plans


Financing Program’s Financing Program’s Deficit from General Deficit from General

RevenuesRevenues Federal government could provide Federal government could provide

funds using general revenues to funds using general revenues to avoid bankruptcy of programavoid bankruptcy of program

Most likely way future imbalance will Most likely way future imbalance will be addressedbe addressed


Cost of Imbalance in Social Cost of Imbalance in Social Security Revenues and Security Revenues and

ExpendituresExpenditures Federal government transferring Federal government transferring

assets among its own accountsassets among its own accounts Social security trust fund is an asset Social security trust fund is an asset

and liability to federal governmentand liability to federal government

Holcombe 20

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