Privatizing Social Security

Studies | Social Security

No. 217
Wednesday, July 01, 1998
by Laurence J. Kotlikoff

Social Security's Treatment of Postwar Americans

Figure IV - Lifetime Social Security Taxes and Benefits as of Age 65

7In a recent study, five colleagues and I used a detailed micro simulation model to examine how Social Security is treating postwar Americans.8 In addition to considering the treatment of different postwar cohorts, the study compares the treatment of different types of individuals within each cohort.

"Social Security is a bad deal for postwar Americans and has gotten worse over time."

Modeling methods. The study uses two tools: a dynamic micro simulation model and a detailed Social Security benefit calculator. The simulation model generates a representative sample of lifetime earnings and demographic trajectories for Americans born or to be born between 1945 and 2000. The benefit calculator determines the Old-Age and Survivors Insurance (OASI) benefits received and taxes paid. These benefits and taxes are then used to a) compute the lifetime net benefits (benefits less taxes paid) for different cohorts and subgroups within cohorts of the baby boomers and their children, b) calculate the rate of return different cohorts and groups within cohorts are implicitly earning on their Social Security contributions and c) measure the extent to which the system pools risk across cohort members by reducing the variance of lifetime incomes.

The simulation model starts with a representative sample of Americans alive in 1960. It then "grows" this sample demographically and economically. Specifically, it ages, marries, divorces, fertilizes, educates, employs, unemploys, re-employs, retires and kills original sample members and their descendants over the period 1960 through 2090. The benefit calculator uses completed lifetime demographic and economic experiences to determine retirement, spousal, widow(er), mother, father, children and divorcee benefits as well as taxes.9

Figure V - Net Burden of Social Security As a Percent of Lifetime Income

Overall findings. The study's findings show that Social Security is a bad deal for postwar Americans. Moreover, the deal has gotten worse over time. On the average, out of every dollar postwar Americans are contributing to Social Security, 74 cents represent a pure tax without any offsetting benefits.10 The pure-tax component of each dollar contributed is 55 cents for the oldest baby boomers and 81 cents for today's newborns. The degree of pure taxation is less than 50 cents on the dollar for very low-wage earners and greater than 80 cents on the dollar for very high-wage earners. These losses assume no adjustment to Social Security's taxes or benefits. But, as indicated above, major adjustments are inevitable unless the system is privatized.11

Comparing income groups. In absolute terms, the burden of Social Security appears to be distributed progressively. Today's highest earners pay roughly $1 million in taxes over and above any benefits they can expect to receive, measured as of age 65. The comparable figures are $400,000 for middle-class workers and $50,000 for the lowest earners. [Taxes and benefits for today's 18-year-olds are shown in Figure IV.] However, measured as a proportion of their lifetime labor incomes, the middle class are the biggest losers from Social Security and the overall distribution is somewhat regressive. On the average, postwar middle-class workers pay 8 cents per dollar earned to Social Security in net taxes compared with 5 cents for the lowest-paid workers and only 3 cents for the highest-paid workers. [The distribution for 18-year-olds is shown in Figure V].

"The overall distribution of the Social Security burden is somewhat regressive."

Men vs. women. Men pay about 1 percent more of their lifetime earnings in net taxes than do women. The higher male net tax rates obtain even for men and women earning the same lifetime incomes. This reflects shorter male life expectancy and less frequent receipt of dependent and survivor benefits.

Whites vs. nonwhites. Nonwhites, because of their shorter life expectancies, face slightly higher (about a third of a percentage point) lifetime net tax rates than do whites. This is particularly true at lower levels of lifetime earnings. [See Figure VI for 18-year-olds.]

Figure VI - Net Social Security Burden As a Percent of Lifetime Income

College vs. no college. College-educated workers face somewhat lower (about two-thirds of a percentage point) lifetime net tax rates than non college-educated workers. [See Figure VI for 18-year-olds.] This difference disappears once one controls for lifetime earnings.

Insurance against risks. One rationale for Social Security is that it pools risks - the risk of low wages, the risk of dying early and the risk of a lengthy retirement - through the progressivity of its benefit schedule as well as through its provision of dependent and survivor benefits. The data support this view. Across all postwar age groups, Social Security reduces the variance of lifetime income by 11 percent. Within each age group, Social Security reduces lifetime income variance between 6 and 10 percent.

Rates of return. The internal rate of return earned by those born after World War II on their Social Security contributions is very low. It's also falling. Those born right after World War II will earn, on average, a 2.4 percent real rate of return. Those born in the early 1970s will average about a 1 percent real rate of return, and those born at the end of this decade will average essentially a zero rate of return. [See Figure VII.] These internal rates of return would be even lower if one factored in the massive tax increases or the benefit cuts needed to restore Social Security to long-run solvency.

Figure VII - Real Rates of Return under Social Security by Age Group

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