ECO309: Public Finance Chapters 11-12: Social Security and Income Redistribution

Tanvir Hussain1
1 Assistant Professor Department of Economics and Social Sciences BRAC University

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Introduction

What is social security? Why do countries have social security programs (or social insurance programs in general)? In the context of these chapters, we will be referring to the Old Age Survivors, and Disability Insurance (OASDI). Our objective is to look at social security programs from the perspective of welfare economics. How does social insurance work? During their working lives, members of the system and their employers make contributions via a tax on payrolls. Upon retirement, members are eligible for monthly payments based in part on their contributions. The payments are xed in real terms and lasts as long as the recipient lives. Why would someone want to participate in a policy like the above? Two considerations:
1

If someone dies earlier than expected (during working age), he/she doesnt have enough accumulated savings for family If someone lives longer than expected (after retirement), he/she may not have enough savings to cover all of his/her retirement years

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What is Available in the Market?

Annuity pay a lump-sum premium and, in return, receive a xed annual amount forever. Understandably, larger the premium, bigger the annual payment. Life Insurance pay an annual amount to the insurance company and receive a one time (lump-sum) payment upon death. Both the above are fairly similar they are both used as tools for consumption smoothing. Assuming a certain degree of risk aversion, an individual wants to reduce consumption during high-earning years in order to increase consumption possibilities during low-earning years.1 Obviously, there will be problems of asymmetric information in these markets. One major problem is that of adverse selection:
In case of annuities, the expected prot for the seller depends, critically, on what his/her belief (or average estimate) about the buyers life expectancy. The buyer will always know more about his/her true life expectancy. In time, the seller will only confront a market full of people with higher than average life expectancies.

Read about other justications from the book, e.g., lack of foresight and paternalism.

Recall, from macroeconomics, the lifecycle-permanent income hypothesis.

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Distributional Objectives

Social security aims to achieve: 1. Inter-generational redistribution: benets received in a year must equal payments made in the same year. Formally: Nb B = t Nw w implies B=t Nw w Nb (1)

where, B is number of beneciaries, Nb is average benet per retiree, t is tax rate, Nw is total number of workers covered and w is average wage per covered worker. Two important implications of equation (1):
(a) Assuming a xed tax rate, average benet can only increase if the wage rate increases or the workers to retirees ratio increases (b) One way of increasing average benet is to increase the tax rate; however, this is not really fair for all generations at the same time

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Distributional Objectives

2. Intra-generational redistribution of income:

(a) Life expectancy issues African-Americans gain less lifetime benets than comparable Whites (b) Single males gain lower lifetime benets than single-earner couples (c) Double-earner couples gain lower lifetime benets than single-earner couples

Are these redistributive goals are desirable for the society in general? Depends on value judgements.

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Intertemporal Budget Constraint

A simple two period model, period 0 (present) and period 1 (future). Consumption today is c0 and consumption in future is c1 . A is the current endowment point. Lifetime (or intertemporal) budget constraint is dened by: I1 c1 = I0 + lifetime consumption must equal lifetime income 1+r 1+r where, r is the market interest rate. This budget line is shown below: c0 +
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Figure 1: Intertemporal budget constraint

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Intertemporal Choice
Optimality depends on the location of intertemporal indierence curves (along the budget line). An optimal to the left and above A means consumer saves in period 0 An optimal to the right and below A means consumer borrows in period 0

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Figure 2: Intertemporal utility maximization

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Intertemporal Choice with Social Security

How does the introduction of social security payment (or tax) aect things? The consumer has to make social security contribution equal to $T now, which means the endowment point, eectively, moves to point R. The optimal could, still, be at point E1 , but, one major dierence from before. T c ), which is less than before. With social security, private savings is only (I0 0

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Figure 3: Intertemporal choice and crowding out

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Pattern of Eects

Literature suggests that, in the presence of social security, the following behavioral eects have been observed among people: Wealth substitution eect: The crowding out of private savings due to the presence of social security is known as the wealth substitution eect. In gure 3, private savings is T ) because of social security. reduced (or crowded out) by the amount (I0 I0 Retirement eect: social security may induce people to retire early. Therefore, they would want to save more to nance a higher number of retirement years. Bequest eect: parents may have bequest motive to leave higher savings for future generations. Parents may recognize the fact that childrens social security payments are just distributing their current incomes to future generations.

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Income Redistribution

This section focuses on the distribution of income; more specically, should the government get involved in income redistribution policies? Economists have displayed some tendency to stay away from addressing concerns about distributional issues; but, two obvious problems with this way of thinking: Decisions based (purely) on the grounds of economic eciency will not always be desirable from a normative standpoint. More importantly, economists can ignore normative (or value judgement) questions, but, policy makers (or politicians) cannot.

So, at some point, economists do have to look at normative issues, otherwise, their quantitative analyses alone will not get the policy makers attention. At a minimum, economists should be able to forecast the distributional impacts of their prescribed policies. Read the textbook section on distribution and measurement of income. It describes some of the pertinent features of the United States Census data on income and associated indicators.

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Income Redistribution: Rationales

Utilitarian view: standard theory of welfare economics suggests that societys welfare depends on the welfare of individual members:2 W = F (U1 , U2 , ......, Un ) (2)

where, Ui is the utility function of individual i with a total of n individuals living in the society. The utilitarian view argues that F (Ui ) > 0, that is, an increase in any one persons utility will increase overall welfare (ceteris paribus ). A special case of equation (2) is the additively separable social welfare function: W = U1 + U2 + ...... + Un Suppose the governments problem is to:
n

(3)

Maximize:

W =
i =1

Ui

(4)

Assuming a social welfare function can be reached based on individual preferences.

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Government Welfare Maximization

Under the following set of assumptions, maximization of the additive social welfare function yields clear results: Utility functions are identical across individuals, where, utility only depends on income. Denitely, a troublesome assumption; always impossible to determine whether individuals have identical utility functions. One defense is that the government should act as if individual functions are identical. Each utility function exhibits diminishing marginal utility of income. A technical assumption necessary for redistributive policies to have any impact on social welfare. Aggregate income (total endowment) is xed for the society as a whole. Another technical assumption, simply asserts that the size of the pie is not changing as government redistributing income.

Assuming the above are true, the maximization problem in equation (4) yields the result that the government should redistribute income so as to attain complete equality of income across individuals.

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Optimal Distribution of Income

Consider a simple two person society with Paul and Peter. The horizontal distance (OO ) measures the total available income, that is, any point along the horizontal axis shows a combination of Pauls and Peters income. The two vertical axes measure the marginal utilities, which are both downward sloping. And, because the utility functions are identical, the MUPeter curve is a mirror image of the MUPaul curve.
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Public Finance

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Figure 4: Optimal distribution of income

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Optimal Distribution contd.

Imagine that, initially, Paul has income Oa and Peter has income O a, which means Peter is richer than Paul. Are there possibilities of increasing social welfare by way redistributing income between Peter and Paul? Consider that the government is thinking of redistributing income ab from Paul to Peter. What are the implications? Geometrically: Pauls gain in total utility = area abfe Peters loss in total utility = area abdc Net gain in social welfare = (abfe abdc ) = area cefd Individually, of course, Peter is worse o and Paul is better o, but, social welfare is increasing. Social welfare continues to change (increase or decrease) until income I is reached where: MUPaul = MUPeter IncomePaul = IncomePeter

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