1
Chapter 9 – Social Insurance
I,Social Security and
Unemployment Insurance
Public Economics
2
Social Insurance Programs
? Generally share 4 characteristics:
– Participation is mandatory
– Eligibility and benefits depend on prior
contributions
– Benefits begin with an identifiable occurrence
– Programs are not means-tested
3
Why have Social Insurance?
? Recall that the First Welfare Theorem
concluded that private markets generally
work well.
? One critical difference in insurance
markets is asymmetric information – one
party has information that is not available
to the other party.
4
Why have Social Insurance?
? If a private firm offers insurance and
cannot observe the high risks from the
low risks,likely to get a group of buyers
that is adverse to its interests.
? Adverse selection – Individual who
knows he is especially likely to collect
benefits will have an especially high
demand for insurance.
5
Why have Social Insurance?
? In a perfectly competitive insurance
market,expected profits will be driven
down to $0.
? Adverse selection could lead to insurance
plans losing money,and raising the
premiums only exacerbates the adverse
selection problem.
6
Why have Social Insurance?
? How can government intervention
improve efficiency?
– Social insurance programs are compulsory,
the adverse selection problem is avoided
because the low risks are forced to purchase
the insurance policy as well.
– In the private market,the low risks would be
less likely than the high risks to purchase the
insurance policy.
7
Why have Social Insurance?
? Other justifications
– Lack of Foresight / Paternalism
? For example,some individuals do a poor job
of planning for their retirement.
– Moral Hazard
?,Gaming the system”
– Economize on Decision-making costs
– Income distribution
8
Structure of Social Security
? Many details of Social Security laid out in
the following slides.
? One motivation for presenting these
details is that virtually all college students
are affect by Social Security,thus,it is
important to understand the details.
9
Structure of Social Security:
Basic Components
? Pay-as-you-go Financing
? Explicit transfers
? Benefit structure
? Age at which benefits are withdrawn
? Recipient’s family status
? Financing
10
Structure of Social Security:
Basic Components
? Pay-as-you-go Financing
– Benefits for current retirees come from
payments made by current workers.
– Early recipients received very high returns on
their contributions.
11
Structure of Social Security:
Basic Components
? Explicit transfers
– Supplemental Security Income (SSI) was
enacted in 1972,and is administered by the
Social Security Administration.
– More accurately viewed as a welfare
program rather than social insurance.
12
Structure of Social Security:
Basic Components
? Benefit Structure
– Average Indexed Monthly Earnings – are
an individual’s average wages throughout
their working life.
? Adjusted for inflation
? Wages up to a ceiling
? Only highest 35 years of earnings
13
Structure of Social Security:
Basic Components
? Only highest 35 years of earnings count
toward AIME.
? Consider a person with a typical,age-
earnings” profile,who starts work at age
22 and retires at 67,and therefore has 45
years of full-time work.
? Likely that the Social Security taxes paid
from ages 22-32 will not matter for AIME.
14
Structure of Social Security:
Basic Components
? Benefit Structure
– Convert AIME into Primary Insurance
Amount (PIA) – basic benefit payable to a
work who retires at the,normal retirement
age.”
– Benefit schedule is progressive,where lower-
earners receive a higher proportion of
previous earnings.
Example of Benefit Calculation
(using 2004 rules)
Average AIME Maximum AIME
$2,774 $5,892
PIA formula
90 percent of the first
$612 of AIME $550.80 $550.80
32 percent of AIME over
$612 and through $3,689 691.84 984.64
15 percent of AIME over
$3,689 0.00 330.45
Total 1,242.64 1,865.89
PIA 1,242.60 1,865.80
16
Structure of Social Security:
Basic Components
? Typical low-earner who retired in 2003
received 64% of AIME.
? Average earner received 48%
? High earner received 40%.
17
Structure of Social Security:
Basic Components
? Age at which benefits are withdrawn
– The normal retirement age is the age at
which an individual qualifies for full Social
Security benefits.
– Can retire as early as age 62,but benefits
are scaled down.
– Benefits are scaled up for retirement after the
normal age.
18
Structure of Social Security:
Basic Components
? Normal retirement age is being ratcheted
up from 65 to 67 for younger generations.
? Implicitly a benefit cut.
Retirement Age is Increasing
Year of birth Normal retirement age
1937 and prior 65
1938 65 and 2 months
1939 65 and 4 months
1940 65 and 6 months
1941 65 and 8 months
1942 65 and 10 months
1943-54 66
1955 66 and 2 months
1956 66 and 4 months
1957 66 and 6 months
1958 66 and 8 months
1959 66 and 10 months
1960 and later 67
20
Structure of Social Security:
Basic Components
? Recipient’s family status
– For a single worker who retires at the normal
retirement age,the monthly benefit equals
PIA.
– A worker with a dependent spouse (or child)
may receive an additional 50% of the PIA.
21
Structure of Social Security:
Basic Components
? Other details
– Up to 85% of the benefits can be taxed by
individuals whose income exceed certain
thresholds.
– Benefits are indexed for inflation.
? Very few financial assets offer this kind of
protection against inflation.
– Earnings test for retirees who have not
reached the normal retirement age.
22
Structure of Social Security:
Basic Components
? Financing
– Payroll tax is a flat percentage of an employee’s
annual gross wages up to a cap.
– Currently,the Social Security part of the payroll tax is
split equally between employer and employee,with
each paying 6.2% of gross wages.
– Likely that much of the employer tax is shifted to
employees in the form of lower wages.
23
Structure of Social Security:
Basic Components
? Financing
– Payroll tax and the cap have increased
dramatically over time.
– In addition to the cumulative Social Security
payroll tax of 12.4%,there is also an
uncapped Medicare tax of 2.9%,resulting in
a cumulative tax of 15.3%.
Social Security Taxes are Capped
Maximum Earnings Taxable,2002 2003 2004
Social Security (OASDI only) $84,900 $87,000 $87,900
Maximum Tax Withheld $5,263.80 $5394 $5,449.80
Medicare (HI only) No Limit No Limit No Limit
25
Structure of Social Security:
Distributional Issues
? Some people benefit more than others
from Social Security
? Given the complexity of the program,how
do economists figure out who wins and
who loses?
26
Structure of Social Security:
Distributional Issues
? Simulate lifetime net benefits for different
representative individuals
– Social Security Wealth,Lifetime value of
Social Security benefits,discounted to
present
– Lifetime costs of being in the system –
payroll taxes.
? See Table 9.3
Table 9.3
28
Structure of Social Security:
Distributional Issues
? Conclusions from Table 9.3:
– Social Security redistributes across income
groups
– Social Security redistributes across
generations
29
Structure of Social Security:
Distributional Issues
? Social Security redistributes in other ways
as well,many of which may be
unintended.
? Life expectancy varies by:
– Race,gender,smoking status
– Social Security redistributes to groups with
higher life expectancies
30
Structure of Social Security:
Distributional Issues
? Social Security also redistributes by living
arrangements due to the 50% PIA adjustment,
Consider benefits for three households:
BEN P IA? 1
Single Individual Married,1 earner
Married,2 earners
BEN P IA? 1 5 1.
? ?BEN P I A P I A P I A P I A? ?m ax,,.,1 5 1 51 2 1 2
31
Structure of Social Security:
Distributional Issues
? Married couples with uncovered spouses gain
relative to single people because of the 50%
PIA adjustment.
? Married couples with uncovered spouses gain
relative to married couples with two earners.
– If the secondary earner would have a sufficiently low
PIA (e.g.,PIA2 is small relative to PIA1),then the
higher PIA (PIA1) entirely determines the benefit.
– All of the payroll contributions for PIA2 in this case are
taxed away.
32
Structure of Social Security:
Distributional Issues
? Economic status of the Aged
– Elderly used to be a relatively disadvantaged
group
– Elderly now have lower poverty rates than
the average household
33
Effects on Economic Behavior
? Saving behavior
? Retirement decisions
34
Effects on Economic Behavior,
Saving behavior
? Life-cycle theory of savings states that
consumption and savings decisions are
based on lifetime considerations.
? Generally want to,consumption-smooth”
? Thus,should save during working years
when income is high,and dissave during
retirement years when income is low.
35
Effects on Economic Behavior,
Saving behavior
? Social Security affects these incentives
– Wealth substitution effect,Households view the
government as doing some of this saving for them
(↓S)
– Retirement effect,Social Security may induce
people to retire earlier,thus more periods of
retirement to finance (↑S)
– Bequest effect,Social Security redistributes from the
young to the old,and parents may offset this with
larger bequests (↑S)
36
Effects on Economic Behavior,
Saving behavior
? Net effect of Social Security on personal
savings decisions is ambiguous.
? Empirical work finds that Social Security
increases consumption and reduces savings
(e.g.,the wealth substitution effect dominates).
? Calculations suggest Social Security reduced
personal savings from $744 to $296 billion.
– Huge negative impact
37
Effects on Economic Behavior,
Retirement decisions
? Dramatic fall in labor force participation
among men over 65
– In 1930,54% in labor force.
– In 2001,18% in labor force
? Many factors may have contributed to this,
including Social Security
38
Effects on Economic Behavior,
Retirement decisions
? Social Security’s adjustments to benefits
create incentives to retire at 65
– Although the benefits are adjusted upward
after that,the adjustments are actuarially
unfair.
– Age at which benefits are first available has
an important effect on likelihood of retirement.
39
Long-Term Stresses on Social
Security
? Given its current pay-as-you-go structure,
Social Security is financially unstable.
? In stable system,benefits received
equals payments collected.
? We can decompose these two parts.
40
Long-Term Stresses on Social
Security
? Benefits received:
N Bb
? Payments collected:
tN ww
? Where Nb=number of retirees,B=average benefit
per retiree,t=tax rate,Nw=number of workers,and
w=average wage per worker
41
Long-Term Stresses on Social
Security
? For solvency,we must have:
N B tN wb w?
? Or rearranging:
t N
N
B
w
b
w
? ?
?
?
?
?
? ??? ???
? The first term on the right hand side is the
dependency ratio,and the second term is the
replacement ratio.
42
Long-Term Stresses on Social
Security
? Dependency ratio has been going down
because of an aging population.
– Currently 3 workers per retiree
– By 2030,0.5 workers per retiree
? Only way to keep system stable would be
to increase taxes or lower benefits.
43
Social Security Reform
? Tweak the current system
– Raise payroll tax,increase retirement age
? Privatize the system
– Contributions earmarked for account where
the person could invest in various assets
– Potentially higher returns (but more variance)
– Has distributional consequences
44
Unemployment Insurance
? Protects against income losses due to
unemployment
? Weekly benefit was $258 in 2002
? Private markets may fail to provide this
insurance because of adverse selection
? Government provision eliminates the adverse
selection problems,but not moral hazard
45
Unemployment Insurance
? Gross replacement rate – proportion of
pretax earnings replaced by UI
– About 50%
? Financed through payroll tax,entirely paid
by employer (on paper,at least)
? Tax is experience rated – firms that lay
off more workers face higher tax rate
46
Unemployment Insurance
? Concerns that UI increases the
unemployment rate
– Moral hazard on the part of employees / job
searchers because of high replacement rates
– Moral hazard on part of firm because of
imperfect experience rating
? Studies suggest that higher benefits do
increase durations of unemployment
47
Recap of Social Insurance I,
Social Security and
Unemployment Insurance
? Social Security
– Basic structure
– Redistribution
– Effects on behavior
– Policy problems and reforms
? Unemployment Insurance
Chapter 9 – Social Insurance
I,Social Security and
Unemployment Insurance
Public Economics
2
Social Insurance Programs
? Generally share 4 characteristics:
– Participation is mandatory
– Eligibility and benefits depend on prior
contributions
– Benefits begin with an identifiable occurrence
– Programs are not means-tested
3
Why have Social Insurance?
? Recall that the First Welfare Theorem
concluded that private markets generally
work well.
? One critical difference in insurance
markets is asymmetric information – one
party has information that is not available
to the other party.
4
Why have Social Insurance?
? If a private firm offers insurance and
cannot observe the high risks from the
low risks,likely to get a group of buyers
that is adverse to its interests.
? Adverse selection – Individual who
knows he is especially likely to collect
benefits will have an especially high
demand for insurance.
5
Why have Social Insurance?
? In a perfectly competitive insurance
market,expected profits will be driven
down to $0.
? Adverse selection could lead to insurance
plans losing money,and raising the
premiums only exacerbates the adverse
selection problem.
6
Why have Social Insurance?
? How can government intervention
improve efficiency?
– Social insurance programs are compulsory,
the adverse selection problem is avoided
because the low risks are forced to purchase
the insurance policy as well.
– In the private market,the low risks would be
less likely than the high risks to purchase the
insurance policy.
7
Why have Social Insurance?
? Other justifications
– Lack of Foresight / Paternalism
? For example,some individuals do a poor job
of planning for their retirement.
– Moral Hazard
?,Gaming the system”
– Economize on Decision-making costs
– Income distribution
8
Structure of Social Security
? Many details of Social Security laid out in
the following slides.
? One motivation for presenting these
details is that virtually all college students
are affect by Social Security,thus,it is
important to understand the details.
9
Structure of Social Security:
Basic Components
? Pay-as-you-go Financing
? Explicit transfers
? Benefit structure
? Age at which benefits are withdrawn
? Recipient’s family status
? Financing
10
Structure of Social Security:
Basic Components
? Pay-as-you-go Financing
– Benefits for current retirees come from
payments made by current workers.
– Early recipients received very high returns on
their contributions.
11
Structure of Social Security:
Basic Components
? Explicit transfers
– Supplemental Security Income (SSI) was
enacted in 1972,and is administered by the
Social Security Administration.
– More accurately viewed as a welfare
program rather than social insurance.
12
Structure of Social Security:
Basic Components
? Benefit Structure
– Average Indexed Monthly Earnings – are
an individual’s average wages throughout
their working life.
? Adjusted for inflation
? Wages up to a ceiling
? Only highest 35 years of earnings
13
Structure of Social Security:
Basic Components
? Only highest 35 years of earnings count
toward AIME.
? Consider a person with a typical,age-
earnings” profile,who starts work at age
22 and retires at 67,and therefore has 45
years of full-time work.
? Likely that the Social Security taxes paid
from ages 22-32 will not matter for AIME.
14
Structure of Social Security:
Basic Components
? Benefit Structure
– Convert AIME into Primary Insurance
Amount (PIA) – basic benefit payable to a
work who retires at the,normal retirement
age.”
– Benefit schedule is progressive,where lower-
earners receive a higher proportion of
previous earnings.
Example of Benefit Calculation
(using 2004 rules)
Average AIME Maximum AIME
$2,774 $5,892
PIA formula
90 percent of the first
$612 of AIME $550.80 $550.80
32 percent of AIME over
$612 and through $3,689 691.84 984.64
15 percent of AIME over
$3,689 0.00 330.45
Total 1,242.64 1,865.89
PIA 1,242.60 1,865.80
16
Structure of Social Security:
Basic Components
? Typical low-earner who retired in 2003
received 64% of AIME.
? Average earner received 48%
? High earner received 40%.
17
Structure of Social Security:
Basic Components
? Age at which benefits are withdrawn
– The normal retirement age is the age at
which an individual qualifies for full Social
Security benefits.
– Can retire as early as age 62,but benefits
are scaled down.
– Benefits are scaled up for retirement after the
normal age.
18
Structure of Social Security:
Basic Components
? Normal retirement age is being ratcheted
up from 65 to 67 for younger generations.
? Implicitly a benefit cut.
Retirement Age is Increasing
Year of birth Normal retirement age
1937 and prior 65
1938 65 and 2 months
1939 65 and 4 months
1940 65 and 6 months
1941 65 and 8 months
1942 65 and 10 months
1943-54 66
1955 66 and 2 months
1956 66 and 4 months
1957 66 and 6 months
1958 66 and 8 months
1959 66 and 10 months
1960 and later 67
20
Structure of Social Security:
Basic Components
? Recipient’s family status
– For a single worker who retires at the normal
retirement age,the monthly benefit equals
PIA.
– A worker with a dependent spouse (or child)
may receive an additional 50% of the PIA.
21
Structure of Social Security:
Basic Components
? Other details
– Up to 85% of the benefits can be taxed by
individuals whose income exceed certain
thresholds.
– Benefits are indexed for inflation.
? Very few financial assets offer this kind of
protection against inflation.
– Earnings test for retirees who have not
reached the normal retirement age.
22
Structure of Social Security:
Basic Components
? Financing
– Payroll tax is a flat percentage of an employee’s
annual gross wages up to a cap.
– Currently,the Social Security part of the payroll tax is
split equally between employer and employee,with
each paying 6.2% of gross wages.
– Likely that much of the employer tax is shifted to
employees in the form of lower wages.
23
Structure of Social Security:
Basic Components
? Financing
– Payroll tax and the cap have increased
dramatically over time.
– In addition to the cumulative Social Security
payroll tax of 12.4%,there is also an
uncapped Medicare tax of 2.9%,resulting in
a cumulative tax of 15.3%.
Social Security Taxes are Capped
Maximum Earnings Taxable,2002 2003 2004
Social Security (OASDI only) $84,900 $87,000 $87,900
Maximum Tax Withheld $5,263.80 $5394 $5,449.80
Medicare (HI only) No Limit No Limit No Limit
25
Structure of Social Security:
Distributional Issues
? Some people benefit more than others
from Social Security
? Given the complexity of the program,how
do economists figure out who wins and
who loses?
26
Structure of Social Security:
Distributional Issues
? Simulate lifetime net benefits for different
representative individuals
– Social Security Wealth,Lifetime value of
Social Security benefits,discounted to
present
– Lifetime costs of being in the system –
payroll taxes.
? See Table 9.3
Table 9.3
28
Structure of Social Security:
Distributional Issues
? Conclusions from Table 9.3:
– Social Security redistributes across income
groups
– Social Security redistributes across
generations
29
Structure of Social Security:
Distributional Issues
? Social Security redistributes in other ways
as well,many of which may be
unintended.
? Life expectancy varies by:
– Race,gender,smoking status
– Social Security redistributes to groups with
higher life expectancies
30
Structure of Social Security:
Distributional Issues
? Social Security also redistributes by living
arrangements due to the 50% PIA adjustment,
Consider benefits for three households:
BEN P IA? 1
Single Individual Married,1 earner
Married,2 earners
BEN P IA? 1 5 1.
? ?BEN P I A P I A P I A P I A? ?m ax,,.,1 5 1 51 2 1 2
31
Structure of Social Security:
Distributional Issues
? Married couples with uncovered spouses gain
relative to single people because of the 50%
PIA adjustment.
? Married couples with uncovered spouses gain
relative to married couples with two earners.
– If the secondary earner would have a sufficiently low
PIA (e.g.,PIA2 is small relative to PIA1),then the
higher PIA (PIA1) entirely determines the benefit.
– All of the payroll contributions for PIA2 in this case are
taxed away.
32
Structure of Social Security:
Distributional Issues
? Economic status of the Aged
– Elderly used to be a relatively disadvantaged
group
– Elderly now have lower poverty rates than
the average household
33
Effects on Economic Behavior
? Saving behavior
? Retirement decisions
34
Effects on Economic Behavior,
Saving behavior
? Life-cycle theory of savings states that
consumption and savings decisions are
based on lifetime considerations.
? Generally want to,consumption-smooth”
? Thus,should save during working years
when income is high,and dissave during
retirement years when income is low.
35
Effects on Economic Behavior,
Saving behavior
? Social Security affects these incentives
– Wealth substitution effect,Households view the
government as doing some of this saving for them
(↓S)
– Retirement effect,Social Security may induce
people to retire earlier,thus more periods of
retirement to finance (↑S)
– Bequest effect,Social Security redistributes from the
young to the old,and parents may offset this with
larger bequests (↑S)
36
Effects on Economic Behavior,
Saving behavior
? Net effect of Social Security on personal
savings decisions is ambiguous.
? Empirical work finds that Social Security
increases consumption and reduces savings
(e.g.,the wealth substitution effect dominates).
? Calculations suggest Social Security reduced
personal savings from $744 to $296 billion.
– Huge negative impact
37
Effects on Economic Behavior,
Retirement decisions
? Dramatic fall in labor force participation
among men over 65
– In 1930,54% in labor force.
– In 2001,18% in labor force
? Many factors may have contributed to this,
including Social Security
38
Effects on Economic Behavior,
Retirement decisions
? Social Security’s adjustments to benefits
create incentives to retire at 65
– Although the benefits are adjusted upward
after that,the adjustments are actuarially
unfair.
– Age at which benefits are first available has
an important effect on likelihood of retirement.
39
Long-Term Stresses on Social
Security
? Given its current pay-as-you-go structure,
Social Security is financially unstable.
? In stable system,benefits received
equals payments collected.
? We can decompose these two parts.
40
Long-Term Stresses on Social
Security
? Benefits received:
N Bb
? Payments collected:
tN ww
? Where Nb=number of retirees,B=average benefit
per retiree,t=tax rate,Nw=number of workers,and
w=average wage per worker
41
Long-Term Stresses on Social
Security
? For solvency,we must have:
N B tN wb w?
? Or rearranging:
t N
N
B
w
b
w
? ?
?
?
?
?
? ??? ???
? The first term on the right hand side is the
dependency ratio,and the second term is the
replacement ratio.
42
Long-Term Stresses on Social
Security
? Dependency ratio has been going down
because of an aging population.
– Currently 3 workers per retiree
– By 2030,0.5 workers per retiree
? Only way to keep system stable would be
to increase taxes or lower benefits.
43
Social Security Reform
? Tweak the current system
– Raise payroll tax,increase retirement age
? Privatize the system
– Contributions earmarked for account where
the person could invest in various assets
– Potentially higher returns (but more variance)
– Has distributional consequences
44
Unemployment Insurance
? Protects against income losses due to
unemployment
? Weekly benefit was $258 in 2002
? Private markets may fail to provide this
insurance because of adverse selection
? Government provision eliminates the adverse
selection problems,but not moral hazard
45
Unemployment Insurance
? Gross replacement rate – proportion of
pretax earnings replaced by UI
– About 50%
? Financed through payroll tax,entirely paid
by employer (on paper,at least)
? Tax is experience rated – firms that lay
off more workers face higher tax rate
46
Unemployment Insurance
? Concerns that UI increases the
unemployment rate
– Moral hazard on the part of employees / job
searchers because of high replacement rates
– Moral hazard on part of firm because of
imperfect experience rating
? Studies suggest that higher benefits do
increase durations of unemployment
47
Recap of Social Insurance I,
Social Security and
Unemployment Insurance
? Social Security
– Basic structure
– Redistribution
– Effects on behavior
– Policy problems and reforms
? Unemployment Insurance
