Chapter 9: Social Insurance: Social Security and Unemployment Insurance Econ 330: Public Finance Dr. Reyadh Faras

1. Chapter 9: Social Insurance: Social Security and Unemployment Insurance Econ 330: Public Finance Dr. ReyadhFaras Dr. Reyadh Faras

2. Social Insurance Definition: • Government programs that replace income losses that result from events outside personal control. Program characteristics: 1. Participation is compulsory. 2. Eligibility and benefit levels depend, in part, on past contributions made by the worker. 3. Benefit payments begin with some identifiable occurrence such as unemployment, illness, or retirement. Dr. Reyadh Faras

3. Why Have Social Insurance? • A. Adverse Selection • Private insurance companies sell policies providing a fixed annual income (called annuities), mostly to large groups. • However annuities are sold to individuals at higher prices because of the adverse selection problem: • individuals who believe they will likely collect benefits will buy policies. • Result: market fails to provide an efficient amount of insurance, therefore mandatory social insurance solves •   the problem by forcing everybody into one big group. Dr. Reyadh Faras

4. B. Other Justifications 1. Paternalism Paternalists argue that individuals lack the foresight to buy insurance for their own good and therefore the government must force them to. 2. Economize on Decision -Making Costs Insurance and annuity markets are complicated, and it is likely to involve time and effort for an individual to choose the right policy. But government programs reduce such costs. 3. Income Distribution In some programs the link between benefits and contributions is weak, making these programs means of income redistribution within the society. Dr. Reyadh Faras

5. Structure of Social Security • The system works as follows: during their working lives members of the system and their employers make contributions via a tax on payrolls. • On retirement, members are eligible for payments based in part on their contributions. • The program also provides benefits for disabled workers and for dependents and survivors of disabled and retired workers. Dr. Reyadh Faras

6. Basic Components • 1. Partially Funded Financing • The system has passed through three schemes: • Fully Funded: taxes are deposited into a fund that accumulates interest, on retirement the principal •  and interest would be used to pay the benefits. • Pay-as-you-go: taxes paid by current workers are used to pay the benefits of current retirees. • Partially Funded (1983-present): benefits paid to retirees come from taxes from current workers • and from the social security trust fund. Dr. Reyadh Faras

7. 2. Explicit Transfers • Social security provides benefits for dependents and survivors of insured workers, thus it does not provide insurance only but transfers of income among individuals. • 3. Benefit Structure • Benefit structure depends on: • Average indexed monthly earnings (AIME): average wage over the length of working life. • Primary insurance amount (PIA): basic benefit payable to a worker who retires at 65, or becomes disable. Dr. Reyadh Faras

8. Age at which benefit is drawn: a worker can retire at 62, but will receive reduced benefits (20% less than 65) • Recipient's family status: a single retiree receives benefits equal to (PIA), but a person with a dependent receives 50% more. • 4. Financing • The payroll tax is a flat percentage (12.4%) of an employee's annual gross wages up to a certain amount. • Half of the tax (6.2%) paid by the employee and half by the employer. • Medicare program tax is 2.9% paid equally by the employee and the employer. Dr. Reyadh Faras

9. Effects on Economic Behavior A. Saving Behavior Social security can alter the amount of lifetime savings for the following reasons: 1. Workers knowing that they will receive retirement incomes, they tend to save less. But since the system  is partially funded, the increase in public savings is less than the decrease in private savings.  Which means that national savings are lower. Dr. Reyadh Faras

10. 2. Workers are induced to retire earlier than they would have because receiving benefits requires leaving the labor force. 3. Parents may save more to provide higher bequests to their children to offset the distributional effects of the system (i.e. children paying parents' benefits). B. Retirement Decisions The system provides incentives for people over 62 to retire, in fact it played a partial role in changing retirement patterns. Dr. Reyadh Faras

11. Long Term Stresses on Social Security • The system will continue having surpluses until 2014, then will run deficits that require the sale of the trust fund bonds, by 2034 surpluses will be exhausted. • A simple formula shows the sources of the problem. In a stable pay-as-you-go system, benefits equal taxes: Nbx B = t x Nw x W • or   t = ( Nb / Nw ) x ( B / W ) • The first term on the right-hand side is the dependency ratio: number of retirees to number of workers. • The second term is the replacement ratio: average benefits to average wages. Dr. Reyadh Faras

12. Problem: dependency ratio is increasing over time. Currently is one-third, by 2030 will be one half. • Solution: 1) increase taxes by 20%, or 2) cut benefits by one-third. Dr. Reyadh Faras

13. Social Security Reform • In dealing with social security financial problems, there are two options available: • A.   Maintain the Current System: • Proponents of social security believe that the system is successful and should be maintained with minor reforms. • For example, if taxes were increased now by 1.89%, and revenues were allowed to accumulate in the trust fund, then the system could be brought into balance over the next 75 years. Dr. Reyadh Faras

14. Alternatively, the replacement ratio could be lowered by raising the eligibility age for benefits or subjecting benefits to higher rates of taxation. • Opponents to the system point the problems mentioned earlier about the system and argue that the public won’t accept further increases in taxes. • For example, obtaining permanent balance to the system requires increasing taxes by 4.7%. Dr. Reyadh Faras

15. B. Privatize the System: • In recent years high attention was given to the possibility of privatizing the system. • Privatization means that workers’ and employers’ contributions are earmarked for each individual’s account. • Workers then invest the funds in various financial assets, particularly mutual funds (composed of stocks and bonds). • On retirement, individuals finance their retirements out of the accumulations in their accounts. Dr. Reyadh Faras

16. The best known privatized system is Chile’s, which was implemented in 1981. • Its main components are: • A. Each worker is obliged to place 10% of its monthly earnings into an account managed by government approved financial services firm. • B. Upon retirement, benefits can be taken either as a series of phased withdrawals or as an annuity. • C. A guaranteed minimum pension is available for those who have been in the system a sufficient number of years; financed from general revenues. Dr. Reyadh Faras

17. Drawbacks of Privatization: • 1. Risk • Privatization exposes individuals to financial risk if the stock market turns down. • Response: risk exists even with the current system with the possible reduction in benefits. • 2. Administration • The costs of running the Chilean system appear to be quite high. • For example, every investment fund has its own management, advertising, and sales expenses. • Also government supervision of the system is expensive. Dr. Reyadh Faras

18. 3. Distribution • The current system is not only an insurance program, it involves income redistribution to the elderly citizens who would otherwise lack a socially adequate level of support. • However, a private system won’t achieve such a goal. Dr. Reyadh Faras

19. Unemployment Insurance • In 1935 congress passed a legislation that led states to establish unemployment insurance (UI) programs to replace income lost due to unemployment. • All workers are covered. • Why UI is provided socially? • Private market fails to provide adequate amounts of insurance in situations in which where adverse selection and moral hazard are important. Dr. Reyadh Faras

20. Workers with the highest probability of becoming unemployed have the highest demand for UI • (adverse selection), this makes private firms providing such insurance to charge relatively high premiums to make a profit. • This prevents many people from buying policies. • At the same time, workers who are able to buy insurance might experience more unemployment than otherwise (moral hazard). Dr. ReyadhFaras

21. Because it is difficult to  determine whether the layoff is the fault of the worker, private firms would pay large amounts to false claims. • Adverse selection prevents firms from providing UI for their employees because it may attract workers who are not interested in long-term employment. • Therefore, a compulsory government program avoids the adverse selection problem and increases efficiency. Dr. Reyadh Faras

22. A.    Benefits • There is a complicated formula that determines the number of weeks for which an individual can receive benefits. • Number of weeks depends on work history and the state in which the person works (in most states 26 weeks). • In most states the gross replacement rate ( proportion of pretax earnings  replaced by UI) is about 50%. • UI benefits are subject to the federal personal income tax Dr. Reyadh Faras

23. B.  Financing • UI is financed by a payroll tax paid by employers only. • Employer’s UI tax liability for a given worker is the product of the employer’s tax rate, tu, and worker’s annual earnings up to the UI tax ceiling. • UI tax differs across employers because it is experience rated (tu depends on the firm’s layoff experience). • Firms with high lay offs generate high demands for benefits, thus they are assigned high tu. Dr. Reyadh Faras

24. C.  Effects on Unemployment • There are concerns that UI increases unemployment. • One possible reason is imperfect experience rating • (increase in employer’s tax is less than worker’s benefits). • UI may make workers more likely to accept employment in industries where the probability of future lay offs is great. Dr. Reyadh Faras

25. UI may induce the unemployed to spend more time looking for work than they would have otherwise. • Is the moral hazard problem empirically important? • A typical finding is that a 10% increase in the net replacement rate of UI increases the duration of unemployment by about 1.5 weeks. Dr. Reyadh Faras