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Chapter 13 Social Security

Death and Taxes

Benjamin Franklin famously wrote that “in this world nothing is certain but death and taxes.” The current chapter is about both.

If you are like most readers of this book, you are at the very beginning of your working life, and you have probably given little thought to your retirement. In the early years of work, you might be asked to make some decisions regarding a company pension plan, but it is still unlikely that you will spend much time thinking about how you will live when your working life is over. This is normal; none of us is very good at imagining at the age of 20 what our life will be like when we are 70. (Even at the age of 30, or 40, or 50, it is hard to imagine life at age 70.)

One message of this chapter, though, is that even though it is hard to think that far ahead, it is also smart to try to do so. From the very beginning of your working life, you will be making decisions that affect your life in retirement. And from the very beginning of your working life, those decisions will—or should—be influenced by something called the Social Security system.

Social Security was born in the Great Depression. Many people suffered tremendous economic hardship in the 1930s. As part of President Franklin D. Roosevelt’s New Deal in the 1930s, the US government established several systems to alleviate such hardships. Social Security—one of the most important—was designed to provide financial assistance to the elderly. More than 170 other countries, big and small, rich and poor, also have social security systems. To take a few random examples, you will find social security in operation in Mexico, France, the United Kingdom, Kiribati, Laos, Azerbaijan, Chile, Andorra, Burkina Faso, Egypt, Cyprus, Paraguay, and Slovenia.

The Social Security system will give you money when you are older, but it takes money from you when you are working. So even if it is hard to think about the effect that Social Security will have on your income in the distant future, it is very easy to see the effect it has when you are working. Workers are required to make Social Security contributions—one of the many kinds of tax that we all pay—with the promise that they will receive reimbursement from the system when they are older. The state of the US Social Security system is therefore something that you should think about long before you receive payouts. Decisions about your personal saving and consumption right now are, or at least should be, directly influenced by your current tax contributions and expectations of your future Social Security payouts.

Opinion polls reveal that Social Security is one of the most well-supported government programs in the United States. Yet the casual reader of the newspapers could be forgiven for thinking that the system is perpetually in crisis. In the 1980s, for example, there was discussion of serious difficulties with the funding of Social Security. A commission headed by Alan Greenspan (who later became chairman of the Federal Reserve Bank) identified problems with the system and recommended a large number of changes, including some increases in Social Security tax rates. These reforms were supposed to ensure the solvency of Social Security well into the future. Yet, a few decades later, proposals for major reforms of Social Security are back under discussion. The exact form that Social Security will take in the coming decades is an open question that will continue to play a major role in political debate.

We explain the details of the system more carefully later in this chapter, but the basic idea is the following. The government taxes current workers and uses those revenues to pay retired workers. When the system was originally set up, the idea was that payments to retired people in a given year would be (approximately) funded by taxes on those working during that year, so the system would be roughly in balance. For many years, this “pay-as-you-go” structure worked fine. In some years, payments to workers were larger than tax receipts, and in some years, they were smaller, but on the whole there was an approximate match between payments and receipts.

In the 1980s, policymakers first began to pay serious attention to the fact that there was a problem with the pay-as-you-go structure. Demographic changes mean that the system is not balanced in the very long run. The number of retirees relative to the number of workers will increase substantially over the next two decades, and without changes, the time will come when tax revenues will no longer be sufficient to match the obligations of the system.

This is not a looming crisis. The best estimates suggest that the system will no longer be able to pay the full amount of benefits near the middle of the century, although there is disagreement on the exact date. The most recent Social Security Trustees report (http://www.ssa.gov/OACT/TRSUM/index.html) predicted this date as 2036, whereas in 2005 the Congressional Budget Office (http://www.cbo.gov/ftpdocs/60xx/doc6074/02-09-Social-Security.pdf) gave a date of about 2054.See the discussion at Charles P. Blahous III and Robert D. Reischauer, “Status of the Social Security and Medicare Programs,” Social Security Administration, 2011, accessed July 20, 2011, http://www.ssa.gov/OACT/TRSUM/index.html; Douglas Holtz-Eakin, “CBO Testimony,” Congressional Budget Office, February 9, 2005, accessed July 20, 2011, http://www.cbo.gov/ftpdocs/60xx/doc6074/02-09-Social-Security.pdf. Of course, changes will almost certainly be made well before this crisis point. But what form should those changes take?

How should we reform Social Security?

This question matters to every single one of us. As workers, we all pay into the Social Security system, and we all anticipate receiving benefits when we are retired. The current discussion will determine both the level of taxes we pay now and the benefits we will receive in the future.

The average person could be forgiven for thinking that the debate over Social Security is complicated, arcane, and impossible to understand without an immense amount of study. In fact, the basics of the system are quite straightforward, and the most important elements of the discussion can be understood using very little economics. In this chapter, we demystify the arguments about Social Security. This will make it easier for you to understand why you pay Social Security contributions, what you can expect to get in the future, and whether the politicians and talking heads are making any sense when they discuss various reforms.

Road Map

At the heart of the economic analysis of Social Security is a very straightforward idea: “forced saving.” Individuals are required to give up some of their income now—income that they could, if desired, have used for current consumption—and, in return, they are promised income in the future. Understanding Social Security from the individual perspective means understanding the impact of this forced saving on individual choices.

Meanwhile, we also need to understand how Social Security looks from a government perspective. Social Security contributions are a source of government revenue, and Social Security payments are an example of a government transfer. These revenues and payments enter into the government’s budget constraint.

From the perspective of an individual, there is a disconnect in time between taxes and payments. Individuals pay taxes during their working years and receive transfers during their retirement years. But from the perspective of the government, taxes and payments take place at the same time. In any given year there are some individuals who are working and paying taxes, and the money they pay into the system is paid right back out to others who are in retirement.

To address questions about reforming the Social Security program, we therefore need to understand (1) the structure of the program and (2) how it interacts with individual choices about consumption and saving. We study how individuals respond to Social Security by using a model of consumption and saving that applies over an individual’s lifetime. Once we understand how individuals make these choices, we ask how Social Security affects their decisions. Then we think about how the government fits into the picture. We study these flows into and from the Social Security program using the government budget constraint, to link changes in the program with changes in taxes.This tool is used elsewhere in the book in other applications, such as Chapter 12 "Income Taxes" and Chapter 14 "Balancing the Budget". In the end, we are able to see how individuals’ consumption and saving decisions are influenced by their beliefs about government behavior.