Chapter Outline

1
Chapter Outline

• 20.1 Overview of Social Security
• 20.2 Old-Age, Survivors, and Disability (OASDI)
  Benefits
• Eligibility
• Types of OASDI Benefits
• Retirement Benefits
• Survivor Benefits
• Disability Benefits
• OASDI Benefit Amounts
• Primary Insurance Amount
• Cost-of-Living Adjustment
• Earnings Test
• Income Taxation of Benefits

2
Chapter Outline

• 20.3 OASDI Financing
• OASDI and HI Payroll Tax
• Pay-As-You-Go Financing
• Projected OASDI Deficits
• 20.4 Understanding Pay-As-You-Go System
• Economic and Demographic Factors Affecting
  Benefits
• Historical and Projected Implicit Rates of Return
  with
• Pay-As-You-Go Financing
• Historical Returns
• Future Returns
• Illustration

3
Chapter Outline

• 20.5 Why Have Social Security?
• Self-Financing COLAs
• Compulsion and Social Adequacy
• Subsidizing Low Wage Workers May be Inevitable
• Earned Rather than Means-Tested Benefits
• Effects on Savings, Capital Formation, and
  Economic Growth
• 20.6 Proposed Changes / Alternatives to Social
  Security
• Changes that Would Maintain the Basic Structure
  of OASDI
• Changes in Benefits and Payroll Taxes
• Investing Trust Fund Assets in Common Stocks
• Crediting the Trust Funds with Any Operating
  Budget Surplus
• Changes that Would Modify the Basic Structure
  of OASDI
• Privatization Proposals
• Converting Social Security to Welfare

4
Chapter Outline

• 20.7 Medicare
• Medicare Benefits
• Medicare Part A Hospital Insurance (HI)
• Medicare Part B Supplementary Medical
  Insurance (SMI)
• Medicare Financing
• Private Coverage to Supplement Medicare
• 20.8 Summary

5
Overview of Social Security

• Old-age, Survivors, Disability, and Health
  Insurance (OASDHI)
• Two components
• OASDI
• HI
• Provides a floor of protection that many augment
• Combines insurance and wealth transfer

6
Overview of Social Security

• Insurance characteristics
• largely self-supporting
• benefits increase with taxes paid
• benefits paid based on events, not based on means
• Transfer characteristics
• ratio of benefits to taxes paid are higher for
  lower income people
• benefits are not pre-funded (pay as you go)

7
Eligibility for OASDI Benefits

• Workers and their dependents are eligible
• Amount of benefits depends on
• Wages earned
• Amount of time working
• Unit of measurement
• earn a quarter of coverage for each 700 in
  annual earnings (in 1998) up to 4 per year

8
Eligibility for OASDI Benefits

• Quarters of coverage Category of Coverage
• 40 quarters
• or 1 per year from fully insured
• age 21 to 62
• 6 quarters currently insured
• 20 quarters during
• 40 quarters ending with disability insured
• onset of disability

9
Types of OASDI Benefits

• Retirement
• similar to defined benefit retirement plan
• Survivor
• life insurance
• Disability
• disability insurance

10
OASDI Benefit Amounts

• Benefits are based on Primary Insurance Amount
  (PIA)
• Calculate average indexed monthly earnings (AIME)
• index past earnings to growth in average wage
  rates so all earnings are comparable
• take highest 35 years of indexed wages
• divide by number of months
• PIA in 1998 90 of first 477 in AIME
• 32 of AIME between 477 and 2,875
• 15 of excess
• 477 and 2,875 are called bend points

11
Relationship of PIA to AIME
12
Retirement Benefits

• Required
• Benefit Payable Cessation of Benefits Insured
  Status Amount of Benefit
• Retired worker Death Fully insured 100 of PIA
  at age 65
• aged 62 or older
• Spouse aged 62 Death (or divorce Fully
  insured 50 of workers PIA
• or older (or divorced if married less than
  at age 65 (or 100
• spouse if married 10 years) of working
  spouses
• at least 10 years) own PIA, if greater)
  
• Spouse under age Non-disabled Fully
  insured 50 of workers PIA
• 62 with dependent dependent child
• child under age 16 reaches age 16
• or disabled child
• Unmarried dependent Age 18 (19 if full-time
  Fully insured 50 of workers PIA
• children elementary or high
• school student
• no age limit if disabled

13
Survivor Benefits

• Benefit Payable Cessation of Benefits Insured
  Status Amount of Benefit
• Spouse under age Age 60 or non-disabled Fully
  or 75 of workers PIA
• 60 with dependent child reaches age 16
  currently insured
• child under age 16 or
• disabled child
• Spouse aged 60 or Death Fully insured 100 of
  PIA at age 65
• older (or divorced
• spouse if married
• at least 10 years)
• Disabled spouse Age 60 or cessation Fully
  insured 71.5 of workers PIA
• aged 50-59 of disability
• Unmarried de- Typically age 18 Fully or 75
  of workers PIA
• pendent children (see Table 20-1) currently
  insured
• Deceased worker Death remarriage subject Fully
  insured 82.5 of workers PIA
• dependent parents to certain limitations at
  age 62 (150 total

14
Disability Benefits

• Benefit Payable Cessation of Benefits Insured
  Status Amount of Benefit
• Disabled worker Death, cessation of Disability
  insured 100 of workers PIA
• disability, or age 65
• (when retirement
• benefits begin)
• Dependents Limits generally similar Disability
  insured Similar to retirement
• (similar categories to retirement benefits
  benefits
• to retirement benefits)

15
Other Features

• Cost of living adjustment
• Earnings test
• Retirement benefits are reduced if wages exceed
  certain thresholds
• Strong disincentive for elderly to work full time
• Income taxation of benefits
• Higher income individuals pay tax on part of
  their benefits

16
OASDI Financing

• Financing from
• Income taxes paid by high income beneficiaries
• Interest on OASDI trust funds
• Payroll (FICA) taxes
• FICA Federal Insurance Contribution Act
• Largest source of funds
• Employer and worker each pay 6.2 of taxable wage
  base
• Maximum taxable wage base in 1998 68,400
• Employer and worker also each pay HI taxes
  1.45 of all wages

17
Pay-as-you-go Financing

• Basic idea
• Current payroll taxes pay current benefits
• No pre-funding
• Exception
• Starting in1983, payroll taxes were increased to
  help fund future benefits
• Trust fund invests in government bonds

18
Projected OASDI Deficits

• Projections indicate large deficits in the future
• Around 2015, payroll taxes
• Trust fund will start to decline

19
Factors Affecting Benefits and Taxes

• Simple framework for understanding pay-as-you-go
  systems
• Average benefit
• payroll taxes/number of beneficiaries
• Payroll taxes
• (tax rate) x (average taxable wage) x (number
  of workers)
• Then, average benefit
• (tax rate) x (average taxable wage) x (ratio
  of workers to beneficiaries)

20
Factors Affecting Benefits and Taxes

• If average benefits are kept constant and taxable
  wages remain constant, then
• tax rates must ?
• if the ratio of workers to beneficiaries ?
• Example
• ratio of workers to beneficiaries in 1997 3.4
• estimated ratio in 2030 2.0

21
Implicit Rates of Return

• Compare taxes paid to benefits receive to
  calculate an implicit rate of return
• Relatively high returns for retirees until the
  early 1990s
• Low expected returns in the future
• Using simple framework
• Long-run implicit return
• ? growth rate in wages population growth rate

22
Why Have Social Security?

• Potential problem with private retirement plans
• Unexpected inflation reduces value of benefits
• Costly for private market to insure against
  inflation risk b/c of the high correlation across
  insureds
• Social security might be an efficient method of
  providing this insurance
• I.e., social security provides cost of living
  adjustments (COLAs)
• Wages track inflation payroll taxes increase
  with inflation benefits can be indexed to
  inflation

23
Why Have Social Security?

• Potential problems with private retirement plans
• Some people will not save enough
• Transfers are therefore inevitable
• Social security might be a way of forcing these
  people to contribute at least something to their
  retirement income

24
Proposed Changes to Social Security

• Changes that maintain the current structure
• Benefit reductions
• Tax increases
• Investing trust assets in common stock
• Crediting trust funds with any budget surpluses

25
Proposed Changes to Social Security

• Changes that modify the basic structure
• Privatization
• Allow workers to invest their payroll taxes on
  their own
• Benefits to existing and new retirees would still
  have to be paid long transition period
• Convert to a welfare program
• Make benefits means tested
• Workers in their 40s, 50s, and 60s would lose
• Moral hazard problem many low income people
  would not save at all

26
Medicare

• Pays medical expenses for persons
• aged 65 and above
• disabled people under 65
• Two main parts
• Part A Hospital Insurance (HI)
• coverage for 90 days of hospitalization
• deductibles and coinsurance
• hospitals are reimbursed according to a schedule

27
Medicare

• Part B Supplementary Medical Insurance (SMI)
• pays for physician, outpatient, home health care
  services
• pays 80 of expenses
• above 100 deductible
• monthly premium is required
• physicians reimbursed based on a fee schedule

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Financing of Medicare

• HI
• Financed by payroll taxes
• Both worker and employer pay
• 1.45 of all wages
• Deficits are forecasted
• SMI
• Beneficiaries pay monthly premiums that cover
  about 25 of the costs
• Remaining 75 is financed from general tax
  revenues