Mini Lecture 7
Question 10: How did Social Security slow economic growth?
Social Security (SS hereafter) is the socialized retirement system in the U.S. that began in the late 1930s. There are two important features of the system.
1. It is pay-as-you go.
This means that current receipts from SS taxes go directly to those that are currently retired in the form of benefits. It is a direct transfer payment from one set of households to another set of households. It is not saved or ‘set aside’ anywhere. In years when there is a surplus, that surplus is just spent on other types of federal spending. This means that the return on SS was very high for those who lived a long time when it first began. Some paid SS taxes for only a few years but where guaranteed benefits for the rest of their lives. (Although back then life expectancy was a little less than 65 years, which was the age when you were eligible for full benefits.) This feature also makes it difficult to end abruptly. If SS were to end with no transition, some who paid SS taxes all their lives would receive no benefits.
This feature makes SS very different from private savings in which you have a legal claim to an individual account like a savings account or a mutual fund. In a well-functioning credit market, most of these private savings are used to finance capital investment by firms.
[Aside: The return you get on SS in a pay-as-you-go system is equal to the growth rate of the population. This is why SS will be in trouble in a few decades: as more and more baby boomers retire the number of those receiving benefits will be greater than the number of those working and paying into the system.]
2. Retirement benefits are directly related to lifetime “contributions” (i.e. SS taxes).
This means that the more you put into the system in the form of payroll taxes, the more benefits you will receive when retired. This feature makes SS similar to private savings from an individual perspective. The more you put into your retirement account, the more you will have for retirement. So from an individual perspective SS and private savings are similar in that you will get back what you put in plus interest.
Suppose the interest rate or return on SS is equal to that you would receive with private savings in the credit market. (In reality, the return on SS is now much lower than the return from private savings, but remember that this was not always the case.)
Assume the average person saves 10% of their income before SS begins. This saving is for future consumption during retirement. Now the government introduces SS which is essentially forced saving. The government now taxes 4% or your income, but you get this back when you retire plus interest (the same interest you get from the bank). Now how much of your income will you put in the bank? The answer is 6%. You will still “save” 10%, but the government is “saving” 4% for you in the form of SS. So now you will only put 6% in the bank.
From an individual perspective nothing has changed, but from a macro-economic perspective a lot has changed. The 4% received by the government goes directly to retired people; it does not contribute to capital accumulation. In other words, SS diverts funds from the credit market. Private household savings decreases from 10% to 6%. In terms of supply and demand, there is a decrease in the willingness to save. The savings supply curve shifts to the left causing an increase in the interest rate and a decrease in investment. The higher interest rate chokes off some capital investment. This in turn leads to a decrease in the rate of capital accumulation which leads to a decrease in economic growth. This ultimately leads to a lower standard of living.
SS à decrease in willingness to save à higher interest rate à decrease in investment à decrease in rate of capital accumulation à decrease in growth rate of the economy
J. J. Arias
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