Chapter 9 Social Insurance I: Social Security and Unemployment Insurance

1. Chapter 9 � Social Insurance I: Social Security and Unemployment Insurance Public Finance

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 affected by Social Security, thus, it is important to understand the details.

9. 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.

10. 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

11. 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.

12. 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.

13. Example of Benefit Calculation (using 2004 rules)

14. 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%.

15. 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.

16. Structure of Social Security:Basic Components Normal retirement age is being ratcheted up from 65 to 67 for younger generations. Implicitly a benefit cut.

17. Retirement Age is Increasing