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CHAPTER 20 Social Security PUBLIC SECTOR ECONOMICS: The Role of Government in the American Economy Randall Holcombe Social Security Largest redistribution program Established in 1935, expanded in 1956 and 1965 Paid for by earmarked payroll tax Pay-as-you-go program Taxes and benefits have continually risen PUBLIC SECTOR ECONOMICS: The Role of Government in the American Economy Randall Holcombe 20-2 Social Security Payroll Tax Established to function as governmentoperated retirement program No need-based requirement to collect transfer Eligibility contingent on having contributed to program in past PUBLIC SECTOR ECONOMICS: The Role of Government in the American Economy Randall Holcombe 20-3 Contributions In form of payroll tax Income taxed at constant rate up to specified maximum level Employer/employee contribute equal amounts Increase in tax rates and maximum wage that can be taxed PUBLIC SECTOR ECONOMICS: The Role of Government in the American Economy Randall Holcombe 20-4 Contributions Table 20.1 Charac teristic s of the Soc ial Sec urity Program for Selec ted Years Year Combined Employer and Employee Tax Rates Maximum Taxable Inc ome Soc ial Sec urity as a Perc entage 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% Note: Tax rates are for Soc ial Sec urity and Medic are. Beginning in 1994 all inc ome above the Soc ial Sec urity maximum taxable inc ome is taxed 2.9 perc ent for Medic are. Sourc e: Statistic al Abstrac t of the United States , various issues. PUBLIC SECTOR ECONOMICS: The Role of Government in the American Economy Randall Holcombe 20-5 Structure of the Tax Social security payroll tax more than 39% of total federal taxes Adheres to benefit principle Criticized on regressive nature PUBLIC SECTOR ECONOMICS: The Role of Government in the American Economy Randall Holcombe 20-6 Burden of Payroll Tax Tax Shifting and Payroll Tax Wages set by supply and demand Who pays tax irrelevant to after-tax income of employee PUBLIC SECTOR ECONOMICS: The Role of Government in the American Economy Randall Holcombe 20-7 Visibility of Payroll Tax Tax levied on employer will be hidden from employee Easy for taxpayers to estimate their share of cost to social security program Double amount shown on W-2 form PUBLIC SECTOR ECONOMICS: The Role of Government in the American Economy Randall Holcombe 20-8 Coverage More than 90% of workers in paid employment are covered by social security program Eligibility Must have worked for 40 quarters in a covered job Benefits paid do not reflect present value of past contributions PUBLIC SECTOR ECONOMICS: The Role of Government in the American Economy Randall Holcombe 20-9 Redistributive Nature of Program Reasons social security is compulsory: Adverse selection Low earners get paid more in proportion to social security taxes than high earners Those who do not fare well likely to bypass system Pay-as-you-go system Requires solvent new contributors to keep system PUBLIC SECTOR ECONOMICS: The Role of Government in the American Economy Randall Holcombe 20-10 Pay-As-You-Go System of Financing Collects contributions from current workers, redistributes them to current retirees as benefits Current contributions not invested Dependent on new individuals entering system Liabilities of social security system unfunded PUBLIC SECTOR ECONOMICS: The Role of Government in the American Economy Randall Holcombe 20-11 Viability of Pay-As-You-Go More new contributors entering system each generation Affected by increasing benefit payments Affected by demographic factors: Population living longer Baby boom People have fewer children PUBLIC SECTOR ECONOMICS: The Role of Government in the American Economy Randall Holcombe 20-12 Political Determination of Benefits and Costs Expect rate of return on contributions to equal growth in national income Program subject to change through political process In self-interest for older generation to vote for higher taxes in exchange for higher benefits PUBLIC SECTOR ECONOMICS: The Role of Government in the American Economy Randall Holcombe 20-13 Social Security and Capital Accumulation Reduces incentive for private saving Funded Pensions Funds from pension substitute for private saving No net effect on aggregate investment Unfunded Pensions Reduction in amount of investment PUBLIC SECTOR ECONOMICS: The Role of Government in the American Economy Randall Holcombe 20-14 Social Security and Capital Accumulation PUBLIC SECTOR ECONOMICS: The Role of Government in the American Economy Randall Holcombe 20-15 The Growth of the Social Security Program Original tax was combined rate of 2 percent on income up to $3,000 annually Today is 15.3 percent on income up to $84,900 In 1950, expenditures equaled 7.5 percent of assets Today, 32.3 percent of assets PUBLIC SECTOR ECONOMICS: The Role of Government in the American Economy Randall Holcombe 20-16 Social Security as an Investment Social security as good investment depends on: Structure of future system Future tax rates Higher rates imply higher benefits Growth of future income in country PUBLIC SECTOR ECONOMICS: The Role of Government in the American Economy Randall Holcombe 20-17 Future of Social Security Will pay out more in benefits than it receives in revenues within a few decades Possibility of tax increases Possibility of benefit cuts PUBLIC SECTOR ECONOMICS: The Role of Government in the American Economy Randall Holcombe 20-18 Proposals for Reform System’s current status produced only through continual tax increases Suggestions have been made for reform to overcome the system’s main weaknesses PUBLIC SECTOR ECONOMICS: The Role of Government in the American Economy Randall Holcombe 20-19 Insurance and Welfare Reformers have suggested separating insurance and welfare functions of the system Insurance plan should pay benefits as a function of earlier premiums paid Welfare system to pay additional benefits based on need PUBLIC SECTOR ECONOMICS: The Role of Government in the American Economy Randall Holcombe 20-20 Other Reform Proposals Raising the retirement age Eliminating pay-as-you-go Instituting mandatory private pension plans PUBLIC SECTOR ECONOMICS: The Role of Government in the American Economy Randall Holcombe 20-21 Financing Program’s Deficit from General Revenues Federal government could provide funds using general revenues to avoid bankruptcy of program Most likely way future imbalance will be addressed PUBLIC SECTOR ECONOMICS: The Role of Government in the American Economy Randall Holcombe 20-22 Cost of Imbalance in Social Security Revenues and Expenditures Federal government transferring assets among its own accounts Social security trust fund is an asset and liability to federal government PUBLIC SECTOR ECONOMICS: The Role of Government in the American Economy Randall Holcombe 20-23