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28.5 Social Security in the Real World

Learning Objectives

After you have read this section, you should be able to answer the following questions:

  1. What aspects of the real world are highlighted, and which are missed in our simple framework?
  2. Why do people disagree about Social Security reform?

Our discussion of Social Security deliberately used a simple framework. Using that framework, we first showed that, in the simplest case, the Social Security system actually has no effect on the lifetime consumption of households. We also explained that, once we move away from this simple setup, there are some arguments both for and against a Social Security system.


The world is much more complicated than our simple framework, and we need to make sure that our analysis has not left out some important feature of the real world that would change our conclusion. In this section, we briefly discuss some complications to our model. Some of these complications provide some additional reasons to support a Social Security system; others identify additional costs of the system. However, these additional costs and benefits are much less important than those we have already identified.

Positive Real Interest Rates

We based all our discussion on an assumption that the real interest rate is zero. When the real interest rate is zero, it is legitimate to add real income in different years and consumption in different years. With a real interest rate of zero, adding income levels in different periods is not a problem. But if the real interest rate is positive, this is not correct. To add income and consumption in different years, we have to calculate discounted present values.

Toolkit: Section 31.5 "Discounted Present Value"

You can review discounted present value in the toolkit.

Suppose you will receive some income next year. The value of that this year is given by the following equation:

 discounted present value =next year's income1+real interest rate.

Income earned in the future has a lower value from the perspective of today. The mathematics of the lifetime budget constraint is harder once we allow for nonzero interest rates, so we will not go through the formal calculations here. Without going through all the details of the analysis, what can we conclude?

The main observation is a rather surprising one. Once we introduce a positive real interest rate, the Social Security system makes people worse off. Remember that we concluded earlier that the system had no effect on the total resources in the hands of the household. Households are taxed when they are young, though, and get that money returned to them when they are old. With positive real interest rates, they would strictly prefer the money when they were young.

This result seems odd. A Social Security system allows the government, in effect, to borrow from the future, taxing younger generations to pay older generations. So how does it end up making people worse off? A key part of the answer is that, when the system was first introduced, the first generation of old people obtained benefits without having to make contributions. In the past, therefore, the introduction of the Social Security system did make one group of people better off.

Economic Growth

As we know, most economies grow over time. We neglected this in our analysis. Economic growth has two implications for Social Security: one unimportant and one more significant. First, economic growth is another reason why individuals’ incomes increase over the course of their lifetimes. We have already observed that this does not change the fundamental idea of lifetime consumption smoothing: you still add lifetime income in both working and nonworking years and then divide by the number of years of life to find the optimal level of consumption.

More interestingly, economic growth also means that Social Security payments increase over time. As the income of workers increases because of economic growth, so too does the amount of tax collected by the government. If the Social Security system is in balance at all times, Social Security payments must also increase. Thus when workers are retired, they continue to enjoy the benefits of economic growth. (In fact, if the growth rate of the economy happened to be the same as the real interest rate, the effect of positive economic growth would exactly offset the negative effect of real interest rates.) Normally, the effect of economic growth partially offsets the negative effect of positive real interest rates.

Access to Credit Markets

In our setting, individuals were able to save without difficulty at the market real interest rate (which was zero in our basic formulation). In the jargon of economics, individuals have good access to credit markets. Yet many individuals in reality have a limited ability to borrow and lend.In our example, individuals wanted to save and not to borrow because they obtained income early in life. If we made more realistic assumptions about the patterns of wages over the lifetime, we would typically find that people want to borrow at certain times of their lives. For example, people often borrow early in life to finance their education. There is ample evidence that many people do not actively participate in stock markets: they do not hold mutual funds or shares of individual companies’ stocks. Such individuals typically save by putting money in a bank, and the interest they earn is relatively low. In particular, it is lower than the interest that the Social Security Trust Fund can earn.

Social Security in effect allows the government to do some saving on behalf of individuals at a better interest rate than they themselves can earn. Thus individuals who do not have good access to capital markets can be made better off by access to a Social Security system.

This is in some ways the exact opposite of the argument for privatization. Supporters of privatization argue that if individuals can make their own investment decisions, they can earn a better interest rate than is provided by Social Security. They point out that, on average, the stock market provides a better rate of return than is provided by the system. This argument is correct: people may be able to do better. We need to recognize, though, that these higher returns would come at the cost of higher risk—which brings us right back to the original argument for why we need a Social Security system.

Moral Hazard

Finally, because Social Security serves as a form of insurance, it is subject to problems that are faced by all insurance systems. One of these goes by the name moral hazardAn incentive problem that arises when the provision of insurance leads individuals to make riskier choices., which simply means that the presence of insurance may cause people to change their behavior in bad ways. For example, if people have fire insurance, they may be less likely to keep a fire extinguisher in their homes. Similarly, because people know that the government will provide them with Social Security, they have less incentive to manage their own saving in a careful manner.

Why Do People Disagree about Social Security?

President George W. Bush’s suggestions for reforming the Social Security system encountered a lot of opposition and rapidly became a partisan issue in US politics. Yet it seems as if Social Security is a program that we could analyze completely and carefully using the tools of economics. Why is a basic economic program such as Social Security so politicized?

Some people, of course, will view any proposal from the perspective of politics. There are undoubtedly people who supported President George W. Bush’s proposals not on their merits or demerits but just because they support the Republican Party. Likewise, there are surely Democrats who opposed the president’s proposals simply because they came from a Republican. But leaving such extreme partisan viewpoints aside, there are still good reasons why reasonable people might have different opinions on Social Security:

  • People differ in their assessment of the importance of market failure in insurance markets. A key argument for Social Security is that private markets do not permit people to insure themselves against the risk of poverty in old age. Insurance and annuity markets do exist, so some people argue that this failure of markets is no longer very significant. At the same time, it requires financial sophistication to take advantage of these markets. Many people do not have the expertise to use these markets or access to financial professionals who could advise them.
  • People differ in their beliefs about whether individuals can make good decisions about lifetime consumption and savings. Economists generally think that individuals are the best judges of their own well-being. As a consequence, economists are suspicious of arguments that suggest that the government knows better than you do how you should make your own private decisions (such as how to manage your money). However, the decision making required for lifetime financial planning is very complicated, and the consequences of error are so severe, that many economists nonetheless think that failures of individual decision making are a good reason to support Social Security.
  • People differ in their beliefs about how much government should be involved in people’s lives. Some people are, in general, philosophically opposed to significant government involvement in individual decisions. Even if individuals make poor decisions about their lifetime consumption and savings and end up poor, these people would argue that individuals should bear the consequences of their own mistakes, and government should not bail them out. Others tend to the view that government has a critical role to play in protecting the unfortunate and unlucky.
  • People have different views about fairness and equality. Some people have the view that an important function of government is to protect the worst off in society and to redistribute some resources from those who are relatively rich to those who are poorer. Such people tend to be strong supporters of programs such as Social Security because it protects those who, through bad luck or poor decisions, would otherwise end their lives in poverty. Others disagree, saying that government should not be involved in redistribution of resources. They also point out, as we observed earlier, that Social Security, by its very nature, benefits those who live for a long time, so it is not a good deal for groups with lower life expectancies.

Beyond Social Security

You may have heard in the news that discussion of the need to reform Social Security applies to other government programs. In particular, if a part of the Social Security program is a growing imbalance in the age distribution, then other programs that support transfers to older people are potentially in trouble as well.

A leading example of this is the Medicare program.You can find information about this program at This program provides health care to the elderly. A second example is Medicaid, which is also a publically funded program, administered at the state level, to provide health care; this program is intended to provide assistance to poor people.“Medicaid Program—General Information,” US Department of Health and Human Services, June 16, 2011, accessed July 20, 2011, These programs, like Social Security, entail large outlays by the government. In his testimony in June 2008 to the Senate Finance Committee, Peter Orszag, the director of the CBO, stated the following: “The Congressional Budget Office (CBO) projects that total federal Medicare and Medicaid outlays will rise from 4 percent of GDP [gross domestic product] in 2007 to 12 percent in 2050 and 19 percent in 2082, which, as a share of the economy, is roughly equivalent to the total amount that the federal government spends today. The bulk of that projected increase in health care spending reflects higher costs per beneficiary rather than an increase in the number of beneficiaries associated with an aging population.”“The Long-Term Budget Outlook and Options for Slowing the Growth of Health Care Costs,” Congressional Budget Office, June 17, 2008, accessed July 20, 2011, This quote contains two key ideas. First, it seems likely that outlays for these two programs will be growing rapidly over the next 50 or so years. From the CBO projections, the share of spending on Medicare and Medicaid grows while the share of spending on Social Security is basically constant after 2020.This comes from figure 1 of the following testimony: “The Long-Term Budget Outlook and Options for Slowing the Growth of Health Care Costs,” Congressional Budget Office, June 17, 2008, accessed September 20, 2011, Second, in contrast to Social Security, the problem is not only demographics. Instead, as noted in the testimony, a significant part of the increased cost of these programs comes from the increases in treatment per individual, rather than the number of individuals.

Thus as you use the tools provided in this chapter to ponder Social Security, keep in mind that other programs have similar budgetary challenges. Long-term solutions are needed either to finance the projected increase in outlays or to reduce the costs of these programs.

Key Takeaways

  1. The framework we presented captures the idea that saving is used to smooth consumption over a lifetime, and lifetime income includes taxes paid during working years together with retirement benefits. The framework did not allow for positive real interest rates or economic growth. It also ignored uncertainties of life.
  2. Much of the disagreement about Social Security can be traced to a debate about its value in terms of providing insurance over uncertain lifetimes and the ability of individuals to act in their own interests when making consumption and saving choices.

Checking Your Understanding

  1. Give two reasons why there is disagreement about Social Security reform.
  2. What does it mean not to have access to credit markets?
  3. What other government programs are facing budgetary problems? Are the sources of these problems the same as Social Security?