Public Finance (MPA405)

Dr. Khurrum S. Mughal

Lecture 19: Social Security and Social Insurance

Public Finance

Pay-as-you-go Pension System

• In an unfunded defined benefit pension– no assets are set aside and the benefits are

paid for by the employer or other pension sponsor as and when they are paid.

• Pension arrangements provided by the state in most countries in the world are unfunded, with benefits paid directly from current workers' contributions and taxes.

Pay-as-you-go Pension System

• Economic Theory– Distorts saving and work choices– No conclusive evidence confirms this

• Combined effect of influence on choices of– Those who pay taxes to finance– Those already receiving or close to receiving– Our analysis is for those who are eligible

Impact of Social Security on Savings and Work Incentives

Income and Substitution Effects

• The Substitution Effect leads to decreased saving and work.

• The Income Effect may lead to an increase or decrease in savings and work. Most economists believe the income effect also decreases savings and work.

• We discuss the impact of pension and earnings test on worker’s work incentive

Social Security Pensions and the Work-Leisure ChoiceIn

co

me

pe

r D

ay

Leisure Hours per Day

24

$30

A

A

G B

0 4 9 19 14

U2 F

H

• Worker not of full retirement age, subject to earnings test

• Subsidy shifts Budget Line up with $30 and decreases its slope with more leisure

• Point H: $6 per hr, 5 hrs per day, 19 hrs of leisure

• 15 Hrs per day, $90 per day, 9 hrs for leisure and pension reduced to zero.

– $60 more than wage subject to earnings test

– Pension = 30-60/2=0

• Income effect – some earnings without work

• Work increases work income but reduces transfer income

– An incentive to substitute

Social Security Pensions and the Work-Leisure Choice

• Retiree older than the normal retirement age– Not subject to earnings

test

• Equilibrium at point E before retirement

• At E` after retirement• Only income effect

C

A

G

B

L1 L2

E E'

0

B

$30

24

Inco

me

per

Day

Leisure Hours per Day

U2

U1

Savings Incentives of Social Security

• Asset Substitution Effect: People save less than they would if Social Security did not exist because they are substituting government promises of a benefit for private savings. Stated simply, people save less because government is “saving” for them. 

• Induced Retirement Effect: People save more than they would if Social Security did not exist because they would not have retired or would not have retired as early had Social Security not been there. Given that it does exist, people choose to ultimately retire or retire earlier and save in order to do so. 

• Bequest Effect: People save more than they would have if Social Security did not exist in order to give more to the children and grandchildren when they die.

The Asset Substitution Effect

• Saving CB for future use in absence of Govt Program

• Tax T and promised future consumption G

• T less than S, the amount worker would otherwise save annually

• Lesser resources at hand to save

• AFD – trade current consumption for future

• Still saves CD• Asset Substitution effect

– Reduction in savingCo

nsu

mp

tio

n p

er Y

ear

afte

r R

etir

emen

t

Consumption per Year Prior to Retirement

0

A

A

R

GF

S

TS' BC D

Social Security Pension

U1

E

The Asset Substitution Effect

Co

nsu

mp

tio

n p

er Y

ear

afte

r R

etir

emen

t

Consumption per Year Prior to Retirement

B

A

B C D 0

G2

R2

T

S

Social Security Pension

U2 U1

F E

• At U2 - Saving CB for future use in absence of Govt Program - R2

• Tax T and promised future consumption G2

• T less than S, the amount worker would otherwise save annually

• Point F on U1

• AFD – trade current consumption for future

• Savings fall to zero• Pension plan too generous for

her preferences

• Excess burden - U1 < U2

Savings Incentives of Social Security

• Induced Retirement Effect: People save more than they would if Social Security did not exist because they would not have retired or would not have retired as early had Social Security not been there. Given that it does exist, people choose to ultimately retire or retire earlier and save in order to do so. 

• Bequest Effect: People save more than they would have if Social Security did not exist in order to give more to the children and grandchildren when they die.

The Net Effect of Social Security on Savings

• Martin Feldstein: Social Security leads to a substantial reduction in savings – Asset Substitution Effect

• Alicia Munnell: The net effect of the Asset Substitution Effect and Induced Retirement Effect is nearly zero 

Government and Health Care

Public Finance

Why Health Care is Different

• Uncertainty: – People do not typically know what their health

care expenses will be. • Insurance:

– Because of uncertainty people typically buy health insurance.

– This means that people do not typically pay the full marginal cost of their health expenses.

Health Insurance and the Market for Health Care

Pri

ce (

Do

llar

s p

er U

nit

Ser

vice

)

P2

P *

P1

Q* Q1

B

A

C Loss in Net Benefits

Supply =Marginal

Social Cost

Demand = Marginal Social Benefit

Health Care Services per Year

Implications• Patients:

– After deductibles, patients only pay a fraction of expenses on surgery, stay, and drugs.

– People visit for minor ailments– Their demand increases 

• Hospitals: – To meet the demand they hire more resources. – People only pay a fraction so they prescribe more tests and

other services than they normally would do.

• Amount paid by 3rd parties area P1P2AB