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SOCIAL SECURITY
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CHAPTER OUTLINE
The Basics
Why Do We Need Social Security?
Social Security’s Effect on the Economy
Whom Is the Program Good For?
Will the System Be There for Me?
Summary
LEARNING OBJECTIVES
LO1: Describe what Social Security is and its basic tax and benefit structure.
LO2: Detail the history of changes to the program since its inception.
LO3: Explain the economic rationale for having such a system.
LO4: Enumerate the effects of the program on work and savings.
LO5: Show how economists use present value analysis to aid in determining for whom the program works and for
whom it does not.
LO6: Explain the origin and purpose behind the Social Security Trust Fund is.
LO7: Summarize present estimates of the future financial health of the Social Security system and evaluate the
options for ensuring its long-run solvency.
KEY TERMS
Pay-as-you-go pension- A system where current workers’ taxes are used to pay pensions to current retirees.
Fully funded pension- A system that has an amount currently invested that is sufficient to pay every benefit
dollar it is required to pay in the future.
Payroll taxes- Taxes owed on what workers earn from their work.
Maximum taxable earnings- The maximum of taxable earnings subject to the payroll tax.
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Average index of monthly earnings (AIME)- The monthly average of the 35 highest earnings years adjusted for
wage inflation.
Primary insurance amount (PIA)- The amount single retirees receive in a monthly check if they retire at their
retirement age.
Retirement age- The age at which retirees get full benefits.
Externalities- Effects created by an unregulated market on people other than the buyer or seller.
Asset substitution effect- Government is saving for you; thus you will save less for yourself.
Induced retirement effect- People need to save more if they are going to retire earlier than they would have
without Social Security.
Bequest effect- People save more to give larger gifts to their descendants, thus increasing national savings.
Social Security Trust Fund- A fund established in 1982 to hold government debt which will be sold as necessary
when tax revenues are less than benefits.
Means test- Determination of the amount of one’s government benefit on the basis of income or wealth.
DISCUSSION QUESTIONS
1. How and why was the Social Security system created?
2. What is the difference between a pay-as-you-go system and a fully funded pension program?
3. What is the technical name for Social Security taxes and how do these taxes differ from an income tax?
4. Explain the term “maximum taxable earnings,” and how the Social Security tax is calculated.
5. How is the Primary Insurance Amount (PIA) calculated?
6. How are Social Security benefits determined?
7. How have the Social Security taxes and the retirement age changed since the inception of the program?
8. Who has benefited from the Social Security program, and who would have been better off with a private
investment program?
9. What effect has the Social Security system had on work and savings?
10. What does the future hold for the Social Security program?
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THE WEB-BASED QUESTION
Each year, the Trustees of the Social Security and Medicare trust funds report on the current and projected
financial status of the two programs. Follow the link below to the 2013 report and answer the questions
below.
www.ssa.gov/OACT/TRSUM/index.html
1. Which program (Social Security or Medicare) will run out of funds the soonest?
2. When is it estimated that the Social Security Trust Fund reserves will be used up?
3. When is it estimated that the Hospital Insurance Trust Fund reserves will be used up?
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ANSWERS TO STUDY QUESTIONS
SUGGESTED ANSWERS TO THE DISCUSSION QUESTIONS
1. The Social Security system was created in 1935 when President Franklin D. Roosevelt signed the Social
Security Act into law. During the depression, many people who had diligently saved for their retirement lost
their life savings due to the stock market crash and the bank foreclosures. Social Security was established to
provide a social safety net for retirement income.
2. Social Security is a pay-as-you-go system, which means that current workers’ taxes pay for the current
pensions. In a fully funded pension program, sufficient funds have already been invested. For every benefit
dollar that the program is required to pay in the future, there is currently an offsetting amount, which has been
invested and will be sufficient to pay off that dollar.
3. The technical name for Social Security taxes is Federal Insurance Contribution Act taxes (FICA). These taxes
differ from an income tax in that they are payroll taxes, which are determined by the amount of money that
people earn for their work. Income from dividends, interest, and other unearned incomes are not taxed.
4. The term “maximum taxable earnings” is the maximum level of income that is taxed under the Social Security
tax system. In the year 1937, that income level was $3,000, and in 2007, the maximum taxable income level
had risen to $97,500. Any earned income over this level is tax-free. The employee’s Social Security tax is a
flat tax rate up until the maximum taxable earnings. In the years 1990 through 2003, that rate remained at
7.65% (6.2% is the Old-Age and Disability tax rate and 1.45% is the Medicare tax rate). In addition, the
employer must also pay the exact amount as the employee in taxes.
5. The Primary Insurance Amount (PIA) is the amount single retirees receive in a monthly check if they retire at
their retirement age. It is based on the Average Index of Monthly Earnings (AIME), which is the monthly
average of the 35 highest earning years adjusted for wage inflation. In the year 2007, the PIA was calculated
by adding 90% of the first $680 of the AIME, plus 32% of the next $3,420, and plus 15% of the remainder of
the AIME until the maximum was reached.
6. The benefits are determined by an individual’s Primary Insurance Amount (PIA). Single individuals receive
their PIA. Married couples can receive 1.5 times their highest PIA, or they can receive the sum of their
combined PIAs, whichever is higher. Workers can collect full benefits if they work until retirement age but
they will receive only partial benefits if they retire within the three years prior to retirement age.
7. Since the inception of the program, the Social Security taxes have increased from a tax rate of 1% of payroll
with maximum taxable earnings of $3,000 in 1937 to a tax rate of 7.65% and maximum taxable earnings of
$97,500 in 2007. The retirement age has increased from 65 to 67 for all those born after 1960. In 1937, only
the Old Age and Survivor benefits were available, whereas today the program provides Old Age, Survivor,
Disability, and Health Insurance (Medicare) benefits.
8. The Social Security program has clearly benefited the people who retired before 1980. Social Security
provides a similar return as a private investment in the stock market for people who were born between 1935
and the mid-1950s. If people born after the mid-1950s could be guaranteed a return of 8% from a private
investment program, they would be better off with the private investment than with their Social Security
program.
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9. Since Social Security began, fewer people work past retirement age. The Social Security system has both
reduced and increased savings. Savings have been reduced because of the Asset Substitution Effect, which
means that the government is doing the saving for us and we personally need to save less. Savings have
increased because of the Induced Retirement Effect, which means that people plan on retiring earlier than they
otherwise would and therefore they need to save more. Savings have also increased because of the Bequest
Effect. This effect is due to a higher level of savings that older people are now able to accumulate as they can
now afford to give larger gifts to their descendants. Economists dispute the net effect on savings, but there
appears to be a small negative effect.
10. The pay-as-you-go Social Security program faces a problem in the future, as the retired population is growing
at a faster rate than the working population. A reasonable “intermediate” report estimates that there will be
sufficient taxes to pay benefits until 2018. Between 2018 and 2042, it appears that there will be insufficient
tax revenue, and the Social Security Trust Fund that was set up in 1982 can be utilized. By 2042, it is
estimated that the system will be bankrupt and there will be insufficient funds to pay Social Security benefits.
In order to prepare for the time when there will be insufficient funds, the current system needs to be changed.
The options include raising the payroll taxes, increasing the retirement age, cutting the benefits to upperincome recipients, investing the trust fund in corporate stocks and bonds that offer a higher return than
government bonds, and allowing some payroll taxes to be privately invested in privatized individual accounts.
Although privately investing the Social Security funds would offer a greater return, this would create the
possibility of abuse from special interests, and these investments are much riskier and offer no guarantee of
return.
SUGGESTED ANSWER TO THE WEB-BASED QUESTION
1. Medicare's financial difficulties come sooner—and are much more severe—than those confronting Social
Security. While both programs face demographic challenges, rapidly growing health care costs also affect
Medicare. Underlying health care costs per enrollee are projected to rise faster than the earnings per worker on
which payroll taxes and Social Security benefits are based. As a result, while Medicare's annual costs were 3.2
percent of Gross Domestic Product (GDP) in 2008, or about three quarters of Social Security's, they are projected
to surpass Social Security expenditures in 2028 and reach 11.4 percent of GDP in 2083.
2. Social Security Trust Fund reserves are projected to be used up by 2037.
3. Hospital Insurance Trust Fund reserves are projected to be used up by 2017.